Taxability affects the actual economic recovery from a litigation settlement or award. In assessing whether to accept a settlement or make the investment to take a case to trial, tax implications are an important element in the evaluation of risk versus reward.
Generally, whether litigation proceeds are taxed depends on the underlying basis for the claim. This is the “origin of the claim” doctrine, which means that recoveries that replace amounts that would have been taxable if initially received appropriately are still generally taxable when recovered through litigation. For example, a claim for lost profits is still taxable income. An employment claim for lost wages similarly normally retains its original tax treatment. When paid by a current or former employer for severance pay, back pay, etc., the employer will generally withhold income taxes, FUTA taxes, and the employee’s portion of FICA taxes accordingly (any related attorney’s fees award should be separately identified in order to not incur such employment taxes).
There are exceptions. When a claim relates to physical personal injury/illness, Internal Revenue Code section 104(a)(20) allows an exception from gross income for related damages even when lost wages are a component of the award. However, punitive damages, even under these circumstances, are still taxable. Notably, emotional distress is not considered a physical personal injury and such damages are generally taxable unless they are derived from a claimed physical personal injury/illness (however compensatory claims for medical costs are excluded unless a tax benefit has already been taken for such amounts).
In contrast, economic damages that recover a destroyed asset/investment and return the owner to their original circumstances are not taxable. For example, a claim for the value of destroyed property that does not exceed the basis of the property is not generally taxable.
Awards for attorney’s fees fall into their own category. These awards are part of taxable income, whether paid directly by a defendant, on a contingent basis as a percentage of the award, or otherwise by the recovering party. For business income, there is an offsetting deduction for legal expenses that would neutralize this treatment. Certain whistleblower claimants receive the same beneficial offset. However for individuals, the tax treatment has been less favorable and has recently gotten worse under the Tax Cuts and Jobs Act of 2017, wherein attorneys’ fees are no longer available even as a miscellaneous itemized deduction.
All of the above constitutes general guidance regarding federal tax treatment and does not replace consultation with a tax professional. Tax treatment is very fact specific and, as has been aptly demonstrated in recent years, the tax code is ever evolving. There is also potential for federal and state tax differences. It is important to get such consultation early, as it can impact how one may wish to structure a settlement. When a settlement affirmatively allocates amounts to taxable versus tax exempt claims, the tax preparer will generally follow those allocations, assuming they are performed in good faith and in accordance with the settled claims. If no allocation is provided and the settlement is a lump sum amount which crosses both taxable and tax-exempt damage amounts, one may lose potential tax benefits if the taxpayer cannot adequately support the exclusion amount.