Minimizing the Tax Consequences of Awards and Settlements for Personal Injury by Lewis Taub, CPA
Posted on February 14, 2022
by
Lewis Taub
Plaintiffs seeking compensatory and punitive damages for physical injury or mental distress often fail to recognize the tax implications of the lawsuit damages awarded to them. That information typically is revealed by legal counsel, who must have a firm understanding of the nuances of the U.S. tax code and, more importantly, how to apply those distinctions carefully to the facts of their cases prior to any filings or pleading. Failure to do so can be financially devastating to clients.
Under U.S. law, all income is taxable unless the tax code provides a specific exception to that rule. When it comes to damages awards and settlement funds, taxation is determined based on the “origin of the claim,” or the nature of the remedy sought and the facts upon which that underlying claim is made. This means the tax treatment of damages awards depends on what the settlement or judgment payment intends to replace, based on such evidence as the language in plaintiff’s filings, pleadings and the ultimate settlement agreement or court order.
As a matter of law, compensatory damages awarded and received due to an underlying claim of personal physical injury or physical sickness are not considered items of gross income and therefore are not taxable. This exemption from tax applies even when compensatory damages cover wages a plaintiff lost due to physical injury or illness. However, punitive damages arising from physical injuries do not receive the same treatment. They are taxable to the recipient.
By contrast, damages for non-physical injuries, such as emotional distress and psychological suffering, generally are treated as gross income subject to tax at the plaintiff’s ordinary income tax rate. An exception exists when emotional distress can be attributed to a physical injury or sickness. If there is a personal physical injury, compensatory damages for consequential emotional distress related to the injury are also excludible from gross income. In such a case, the proceeds received for both physical injury and emotional suffering would be excluded from income tax.
All this may seem quite straightforward and easy to understand, but if the rules are not properly considered during both the presentation of court cases or in structuring settlements, taxes may not be minimized. Because lawsuits often involve multiple claims of both physical and emotional injury, legal counsel must be careful and deliberate to make distinctions between the two from the onset, even before filing any motions or pleadings.
All settlements must include specific language identifying awards plaintiffs receive for physical injury from amounts they are compensated for emotional injury. A plaintiff who files a tax return classifying an award as nontaxable when the settlement agreement does not specify physical damages will not likely be successful against IRS scrutiny. If the plaintiff pursues the matter through the legal system, it is likely the courts will assess the intent of the party paying damages by examining evidence that includes allegations contained in the plaintiff’s original complaint. This is where word choice is critical. Not only must counsel ensure the text and language used in pleadings and settlement agreements accurately describe the injuries suffered by a plaintiff, but they may also consider citing specific provisions of the tax code exempting qualifying recovery payments to avoid income tax treatment.
The celebration of a substantial legal victory can quickly turn sour when plaintiffs and their counsel fail to consider Uncle Sam and the amount of an award that will need to cover income taxes.
About the Author: Lewis Taub, CPA, is a director in the New York office of Berkowitz Pollack Brant Advisors and Accountants, where he works with entrepreneurial business, multinational and multi-state corporations on tax planning and compliance strategies, including those related to mergers and acquisitions, basis issues and debt restructuring. He can be reached at the CPA firm’s New York office (646) 213-7600 or info@bpbcpa.com.
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