Per Internal Revenue Code section 61 all income is subject to income tax unless excluded in tax law. Therefore, a settlement is taxable income unless the taxpayer proves that an exception applies.
Internal Revenue Code section 104 provides that damages that compensate an individual for personal physical injuries or physical sickness are not taxable income. However, Internal Revenue Code section 104 does not exclude from income damages for personal injuries that are not physical.
Fortunately, Congress and the IRS agree that damages for non-physical injuries are not taxable when they flow from a personal physical injury. H. Conf. Rept. 104-737, page 301 and Internal Revenue Service income tax regulation 26 C.F.R. 1.104-1(c)(1). For instance, a parent’s damages for emotional distress from seeing her child maimed by a reckless driver normally should not constitute taxable income.
Code §104 does not exclude from taxable income damages for emotional distress not derived from a physical injury even if the emotional distress leads to physical injury or physical sickness. Therefore, damages for emotional distress due to professional malpractice in settling a claim for divorce normally should not be excludable under Code §104.
Internal Revenue Code section 104 does not exclude punitive damages from taxable income. However, a limited exception applies in certain states that characterize all allowable wrongful death damages as punitive. Punitive damages in New Jersey do not qualify for the exception
Where a plaintiff sues for both punitive damages and compensatory damages, IRS may maintain that some of the damages are taxable punitive damages. While plaintiff and defendant may agree how to allocate a settlement, IRS is not bound by self serving allocations. Nevertheless, tax counsel may find ways to minimize taxation as punitive damages.
Where damages are personal rather than business in nature, attorney fees to obtain the damages are not deductible. For instance, when a building owner sues a plumber for faulty work, the attorney fees will not be deductible if the building is plaintiff’s home but they may be deductible where the plumber caused plaintiff’s business to flood.
Damages for a personal injury that isn’t physical are taxable income, and attorney fees to recover personal damages are not deductible. Therefore, an individual who recovers damages for a non-physical personal injury must include the full settlement in taxable income even if the defendant pays part of that settlement to the individual’s attorney to cover the individual’s attorney fees.
The above analysis leads to the following conclusions.
1. Punitive damages normally are taxable income, but bringing in tax counsel early in a case may limit the tax.
2. Non-punitive (i.e. compensatory) damages can be taxable income or excluded from taxable income.
3. Compensatory damages due to personal physical injuries or physical sickness are not taxable income.
4. Compensatory damages due to non-physical personal injuries or sickness are taxable income unless the injury flows from a physical personal injury or sickness such as emotional distress due to a loved one’s physical personal injury.
5. Even if all damages are taxable, a plaintiff may not deduct legal fees to obtain damages that don’t relate to a business.
FriedmanLaw can help you determine whether a settlement may be taxable and limit any tax.
