We are thrilled to announce that Prestige Accounting Services Group (previously Prestige Wealth Accounting Group) has joined forces with Bacchetta & Company in an exciting new partnership!
Are Damage Awards Taxable?
Article Highlights:
Physical Injury
Wrongful Death
Emotional Distress
Employment Discrimination
Sexual Harassment
Human Trafficking Restitution
Wrongful Incarceration
Damages Related to Business Interests
Legal Expenses
Frequent questions that arise are: Are amounts received from settlement of lawsuits and other legal remedies taxable? Are the legal fees paid in connection with these payments tax deductible? The tax code specifies that all income is taxable from whatever source derived, unless exempted by the Internal Revenue Code. The tax code does provide an exclusion from income for certain damage awards but not for others. The companion issue to damage awards is the deductibility of the legal fees associated with the damage awards and settlements. This article looks at a variety of situations and the tax ramifications.
Physical Injury - Damages received on account of personal physical injuries or physical sickness are excludable from income whether recovery is by suit or agreement, or the amounts are received as a lump sum or in periodic payments.
When a legal action originates with a physical injury or physical sickness, then all damages (other than punitive) are treated as payments due to physical injury or physical sickness whether the recipient of the damages is the injured party.
Wrongful Death – Is considered physical injury or physical sickness for purposes of the income exclusion. In addition, where state law provides that only punitive damages can be awarded in wrongful death suits, punitive damages are excludable.
Emotional Distress - Emotional distress isn’t considered physical injury or physical sickness for purposes of the income exclusion. However, the tax code allows the exclusion of damages received for emotional distress to the extent not more than the amount paid for medical care related to emotional distress.
Employment Discrimination - No exclusion is allowed for damages received in a suit involving employment discrimination or injury to reputation, which is accompanied by a claim of emotional distress. However, the exclusion would apply to a claim of emotional distress, which was related to a physical injury or physical sickness.
Sexual Harassment Damages and Settlements - Tax reform put restrictions on business deductions related to sexual harassment damages and settlements as well as impacting the taxability of any award or settlement.
Impact on a Business - No business deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement.
Impact on an Award Recipient – Damages for sexual harassment and gender discrimination are not excludable and thus are fully taxable. The issue of sexual harassment qualifying as excludable physical injury or sickness has been in court on several occasions – always with the same result (it’s taxable).
Human Trafficking Restitution Payments - A defendant convicted of a human trafficking offense is required to make restitution payments to the victim. These payments are excludable from the victim’s gross income for federal income tax purposes. The payments may be to compensate the victim for costs of medical services, physical and occupational therapy or rehabilitation, transportation, temporary housing, childcare expenses, lost income, attorneys’ fees and other costs and losses the victim suffers because of the offense.
Wrongful Incarceration - Compensation received for a wrongful incarceration is not taxable. A wrongfully incarcerated individual is defined as either:
(1) an individual who was convicted of a criminal offense under Federal or state law, who served all or part of a sentence of imprisonment relating to such offense, and who was pardoned, granted clemency, or granted amnesty because of actual innocence of the offense; or
(2) an individual for whom the conviction for such offense was reversed or vacated and for whom the indictment, information, or other accusatory instrument for such offense was dismissed or who was found not guilty at a new trial after the conviction was reversed or vacated.
Damages Related to Business Interests – Generally damages related to business interests are income to the business except for damages related to injury to property. The damages are not taxable to the extent the basis of the property is reduced.
Legal Expenses – Unfortunately in most cases the legal fees end up not being deductible. The reason for that is when they are deductible, they are a tier 2 miscellaneous itemized deduction. But the current tax law has suspended all tier 2 miscellaneous deductions through 2025, so the bottom line, with some exceptions explained later, is that the legal fees are not deductible.
Example: Melinda, was injured in an automobile accident and engaged a legal firm to handle her claim with the insurance company. The legal firm’s fee was 40% of the insurance company settlement. The insurance company paid $100,000. The legal firm got $40,000 and Melinda got $60,000. However, since the legal fees are not deductible Melinda ends up paying taxes on the entire $100,000 settlement.
However, there are exceptions. Legal fees related to a taxpayer’s business or rental are deductible as a business expense. If the action was related to property, the expenses would be added to the property’s basis. An above-the-line deduction (meaning it is deductible as an adjustment to gross income, not an itemized deduction) is allowed for attorneys' fees and costs paid by, or on behalf of, a taxpayer in connection with a claim of unlawful discrimination, certain claims against the federal government, or a private cause of action under the Medicare Secondary Payer statute. This deduction is claimed on Form 1040, Schedule 1, line 24h (2021 version).
As you can see, determining what damage awards are taxable and whether the associated legal expenses are deductible is complicated, and even if allowed, a deduction may not provide any tax benefit. As every circumstance is unique, you are encouraged to call this office to determine what the tax ramifications might be in your situation.
More About Us
Get to Know Prestige Accounting Services Group (previously Prestige Wealth Accounting Group)
Offices in Flemington, NJ and Califon, NJ
Our Mission: At Prestige Accounting Services Group (previously Prestige Wealth Accounting Group), we are on a mission to redefine the tax experience for individuals and small businesses. With a focus on personalized service, strategic planning, and expert guidance, we aim to empower our clients to succeed financially with confidence and ease.
Expertise in Action: With a wealth of experience and a team of dedicated professionals, we specialize in individual and small business tax preparation. While we excel in all areas of taxation, our passion lies in serving the unique needs of small business owners in New Jersey. We understand that small business taxation requires specialized knowledge and attention to detail, which is why we go above and beyond to ensure our clients receive the guidance and support they deserve.
Tailored Solutions for Every Client: Whether you're a high-net-worth individual seeking comprehensive tax planning or a small business owner in need of accounting and bookkeeping assistance, we have the expertise to meet your needs. Our team takes the time to understand your specific situation and develop customized solutions that align with your goals and objectives.
Why Choose Us?: What sets us apart from other New Jersey tax firms is our commitment to excellence and innovation in the field of taxation. We don't just prepare tax returns; we provide strategic insights, proactive planning, and actionable advice to help our clients achieve their financial goals. With a team of two CPAs, an EA, and an ERO, we have the expertise and resources to deliver exceptional service and results.
Your Success is Our Priority: At Prestige Accounting Services Group (previously Prestige Wealth Accounting Group), we measure our success by the success of our clients. We are dedicated to building long-lasting relationships, providing unparalleled service, and helping our clients thrive in today's ever-changing tax landscape.
We can't wait for you to experience the Prestige Accounting Services Group (previously Prestige Wealth Accounting Group) difference.
Tax & Small Business Updates
Get the latest in tax and small business updates and issues that affect your finances and growth prospects.