by: Begley Law Group

by Thomas D. Begley, Jr., Esquire, CELA

In resolving litigation, the taxation of the proceeds should always be considered.  There are often income, estate and/or gift taxes that apply.  From a tax standpoint it makes no difference whether the recovery is via a settlement or judgment.  It is often important how the complaint is worded, how the settlement proceeds are allocated, and whether or not a trust should be utilized and, if so, what type of trust.  The origin of the claim will control the tax consequences of the recovery.  If the underlying claim seeks damages based on a contract or a recovery of a property interest, then the damages are taxed as ordinary income or a return of capital.  If the underlying claim is for personal injury involving physical injury or physical sickness, then the damages are excluded as taxable income to the plaintiff or by a third party recipient for damages caused to the injured party.  An example would be a claim for loss of consortium.  For the damages to be excluded from gross income a three-pronged test must be satisfied:  (1) the award must be based on an action for a tort or tort-type right, (2) damages are for a physical injury or physical sickness, and (3) there must be a nexus or link between the damages received and the physical injury or physical sickness that gave rise to the damages.  Nowhere in the Internal Revenue Code, Regulations or Committee Reports is the term “physical injury or physical sickness” defined.

Claims Generally Excludable from Tax

Damages that are generally excluded from income taxation include those received for a physical injury or physical sickness, wrongful death claims from the recovery by the decedent’s estate or by a third party recipient, medical expenses even if attributable to a non-physical injury or physical sickness claim, wrongful birth or wrongful life cases arising from a physical injury or physical sickness, loss of consortium if due to a physical injury or physical sickness, worker’s compensation claims for the employee or the survivor of a deceased employee to the extent that the compensation was for a physical injury or physical sickness, the claim against an estate to the extent that it is a recovery for an inheritance or gift.

Emotional distress claims are only excludable from income taxation if they are attributable to a physical injury or physical sickness or if the amount of the recovery does not exceed the cost of medical care in cases not based on physical injury or physical sickness.

Claims Generally Includable for Income Tax Purposes

Many litigation claims are includable as income for tax purposes.  Punitive damages are always taxable, even if the origin of the claim is a physical injury or physical sickness.  Emotional distress claims are included, unless attributable to the physical injury or physical sickness.

It is unclear whether a bad faith claim is includable or excludable when the origin of the claim is a physical injury or physical sickness.  Worker’s compensation claims are includable to the extent that they are not compensation for a physical injury or physical sickness.  The following claims are includable for income tax purposes:

  • Wrongful discharge
  • Age discrimination
  • Gender discrimination
  • Race discrimination
  • Disability discrimination
  • Employment discrimination
  • Sexual harassment
  • Injury to reputation
  • Interest on damages
  • Recovery by a corporation or business entity (The reason is that a corporation or a business entity can never sustain a physical injury or physical sickness.)
  • Recovery from breach of contract
  • Lost wages

To the extent that the recovery is for injury to a capital asset, no income will be recognized except for the amount by which the recovery exceeds the tax basis of the capital asset lost.  To the extent that the recovery exceeds the cost basis, the recovery is taxed as a capital gain.  The good will of a business is a capital asset.  Where the suit is for loss of good will and loss of profits, it is important to allocate as much as possible to good will.  Monies recovered for compensation for lost profits will be ordinary income.

Where there is a claim against an estate based on contracts, such as a claim of creditors or a claim for salary, the recovery is includable for income tax purposes.

Allocation of Damages

Frequently, recoveries include monies for taxable and non-taxable damages.  Does the plaintiff’s responsibility to allocate the recovery and to demonstrate the legitimacy of the allocation?  The court will not be bound by the language in the settlement agreement, if the allocation is made for tax avoidance purposes only and do not reflect the true substance of the settlement.  Generally courts consider (1) the allegations in the complaint, (2) the evidence presented and arguments made by each party at trial or in discovery, (3) the details surrounding the litigation, (4) the jury award, if any, and (5) whether the defendant was concerned with the allocation and whether the parties conducted an adversarial negotiation.

Other Considerations

  • Qualified Settlement Fund. In cases involving a Qualified Settlement Fund (“QSF”) there is immediate income tax deduction to the defendant.  This often enables the attorney to collect attorney’s fees right away.
  • Structured Settlements. Payments that are a Structured Settlement, including the interest component, are excludable if the origin of the claim is a physical injury or physical sickness.
  • Estate and Inheritance Taxes. Federal and state estate taxes and state inheritance taxes apply on death and must be considered in the allocation.  The year of the decedent’s death is vitally important.
  • Gift Tax. If litigation proceeds are paid to a trust, care should be taken to design the trust to make the gift excludable, if the recovery is significant.  Damages payable to a person not named in the suit constitute a gift and are subject to gift tax rules.  An irrevocable designation of an individual beneficiary on a Structured Settlement is subject to gift tax, unless the beneficiary is an estate or trust.