Categories of Jury and Court Awards
Compensatory Court Awards
As a general rule, court awards compensating for personal loss, such as economic damages from a car, truck or motorcycle accident or a dog bite, and even pain and suffering, are not subject to income tax. In many personal injury settlements or court awards, this is the only portion of the award. However, sometimes the court award includes payments for emotional distress or punitive damages as a result of the defendant’s wrongdoings.
Punitive Court Awards
The purpose of punitive damages is to punish the person or company who caused the harm and to serve as an example and a warning to discourage others from committing the same wrongful act. Punitive damages are taxable and should be reported as "Other Income."
Emotional Distress Awards
Emotional distress damages are not taxable if they are directly tied to damages for physical harm , such as whether damages for physical harm, like medical expenses or lost income, exceed total emotional distress damages. In other words, as long as the emotional distress damages do not exceed physical harm damages, they will likely not be taxed. If not, only a portion of emotional distress damages will be subject to taxation. Emotional distress damages that are not directly linked to physical harm are generally taxable and should be reported as "Other Income." The only exception is when the emotional distress damages are calculated separately from damages for other types of harm, such as through a separate contract provision or separate jury question. In that case, emotional distress damages are at worst partially taxable.
Compensatory Awards are Taxable
The Internal Revenue Service regulations relating to compensatory damages are contained in 26 CFR § 1.104-1. Section 104(a)(2) of the Internal Revenue Code provides:
"(a) In general. In the case of a taxpayer who is a citizen or resident of the United States, gross income does not include –
"(1) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness; or
"(2) amounts received through prosecution of an action under section 503 (relating to civil damages for constitutional violations)."
There are numerous exceptions contained within the regulations. For example, Section 104(a) specifically provides that punitive damages are not excludable from gross income. See 26 CFR § 1.104-1(c) ("Damages received in the form of punitive damages with respect to a claim for personal physical injuries or physical sickness are not excludable from gross income.")
The regulations also provide that punitive damages paid in settlement of an underlying, otherwise excludable claim are included in gross income. "Whenever there is a settlement by means of the payment of a sum of money and a portion thereof, having been arrived at by negotiation, represents payment for punitive damages, the amount so allocated to payment for punitive damages will be included in the gross income of the payee notwithstanding any designation given to such amount by the court or parties." See 26 CFR 1.104-1(e).
The IRS regulations also deny tax-exemption to attorneys’ fees paid over and above the amount necessary to fully compensate victims for the injury incurred. See 26 CFR 1.104-1(c)(2) ("Any portion of an award or settlement that is attributable to interest or attorney’s fees paid to the attorney shall be included in gross income.")
Punitive Awards are Taxable
In most cases, punitive damages awarded by the court are subject to income tax. This is true whether the award is in a personal injury case, employment suit, or a suit for breach of a contract. The IRS has ruled that punitive damages are not taxable if the only award is nonphysical injury damages and no physical injury damages were ever paid. There are a number of cases, however, in which courts have refused to follow the IRS ruling and have held that all punitive damages are taxable. See Kilpatrick v. Commissioner, 786 F.2d 1197 (11th Cir. 1986); Marks v. Commissioner, 947 F.2d 466 (7th Cir. 1991); Elam v. Commissioner, 92 T.C. 1108 (1989); Glickman v. Commissioner, 872 F.2d 589 (5th Cir. 1989). So any taxpayer who treated punitive damages as non-taxable under the IRS ruling was at risk as some courts have issued rulings contrary to the IRS.
Until recently, the IRS had taken the position that punitive damages were not subject to income tax if the plaintiff could demonstrate that physical injury was the "predominant motivating factor" for the award. The IRS also considered punitive damages to have been awarded if the jury was instructed that punitive damages are to be governed by the "preponderance" of the evidence. The IRS has since reversed its position on both issues with regard to the availability of the "exclusive settlement amount" exception, and has announced that the courts are presently showing no inclination to recognize an exception for punitive damages similar to that which has existed for physical injuries. There is no clear authority in the tax code or treasury regulations stating that punitive damages are taxable. However, the case law almost uniformly holds that punitive damages are taxable.
A taxpayer who is determined to take a contrary position may have the return in question audited and may make the same position in court. However, any such argument will be an uphill one. If the amount is substantial, the matter should be referred to a tax attorney experienced in dealing with the IRS.
Emotional Distress Awards Can Be Taxed
Income received for physical injuries is not taxable. In fact, a taxpayer can exclude from income compensation for a personal physical injury or sickness. Internal Revenue Code § 104. This provision covers punitive damages, damages for emotional distress, medical cost, and loss of wages.
An important exception to the general tax free treatment of receipts from physical injuries is the taxability of emotional distress damages. Although damages received for personal physical injuries are excludable from gross income, emotional distress damages are included in gross income unless certain criteria are met.
The exception to inclusion in gross income is limited to damages received for "emotional distress attributable to a physical injury or sickness." Internal Revenue Code § 104(a)(2). Therefore emotional distress damages are excludable for all cases filed after August 30, 1996. Rev. Proc. 97-34, C.B. 1997-2, 442. The regulation provides that "physical injury or sickness" include a observable bodily harm or a condition in which there is dysfunction of a portion or system of the body . Treas. Reg. § 1.104-1(c)(3).
If the emotional distress arose out of physical injuries or sickness, the damages won will not be penalized by taxation. The troubling issue is that emotional distress damages awarded that do not fit into the regulation’s definition of "physical injury or sickness" will still be included in income. One such example would be an employment case in which the plaintiff experienced extreme mental distress yet had no physical injury or sickness. The damages won would, however, be included in gross income as they do not fall within the confines of the regulation’s definition of "physical injury or sickness." Examples of non-taxed damages for emotional distress are amounts for actual medical expenses attributable to the distress, income lost as a result of the distress attributable to a physical injury, payments for actual damages not attributable to physical injury or sickness, amounts received for physical injuries, and payments for emotional distress for physical injuries.
Filing Court Awards on Taxes
When a plaintiff receives a court award, they generally have to report the proceeds as income on their tax return. On line 21 of IRS form 1040 (for "Other Income") instructions, the IRS states: "Report awards, prizes, or legal damages here… Report nontaxable damage awards and other payments on Form 1040, line 21, unless the award is specifically excluded (for example, certain wrongful death damages). This is where the "FOR" above that we put in quotations matters. The examples that the IRS gives here regarding what is and is not taxable depending on the situation. Let’s take a situation where the injury was caused by a specific act (such as medical malpractice), that can be pointed to as having caused the accident. In this type of situation, the proceeds from the lawsuit would have to be reported on the plaintiff’s taxes, and they would typically be reported on line 21 of IRS Form 1040. On the opposing side, if there is an injury involved that is more generalized and not the direct result of any one act, or is for loss of earning capacity or related types of compensation, then the funds may not have to be reported as taxable income.
Because different scenarios are going to apply in different situations for different people, it is always a good idea to consult an attorney and possibly a tax professional to be sure that taxes that are due are paid, and that the proper forms, such as a W-9 are filled out accordingly.
Tips for Dealing with Taxes on Court Awards
One of the most important things to remember when dealing with a court award is that it is often cheaper in the long run to seek advice on tax structuring before the award is made than after receiving the award. Simply put, if you are awarded a significant sum of money through settlement or through a court award, seek advice from a tax professional immediately. Why? Because tax on court awards can often be minimized through proper structuring of settlements and achieving split settlements when possible. Too often do people come into our offices saying they wish they would have asked about structuring before accepting the award or reaching a settlement. Sometimes we can help , but very often we cannot. For example, clients come in after receiving military disability and lump sum child support instead of alimony, all in the same settlement that is not structured at all. Since they did not ask about it before the award or settlement, even though their negotiator might have been able to split the award for tax purposes, the IRS now has their money. With a little bit of planning before going to court or settling a matter, you can often save more to the government a lot of money through tax avoidance than the amount the attorney seeking tax structuring would charge. It always pays to ask and a good negotiator will work with your tax professional to achieve an appropriate settlement.