When a taxpayer receives an award as the result of a settlement or judgment resulting from a legal action, the question arises as to whether any or all of the award is subject to taxation. The answer depends on what type of damages or losses the award is supposed to replace.
Physical Injuries and Emotional Distress
Any portion of an award that compensated the taxpayer for personal physical injury or illness is not included in income. Recovery for emotional distress is tax-free only if the damages are attributable to a physical injury or sickness. If the taxpayer recovers for emotional distress resulting from a non-physical injury, such as defamation, the award is non-taxable only to the extent of actual medical care expenses attributable to the emotional distress. Any recovery for emotional distress in excess of the medical care expenses must be included in the taxpayer’s income.
Recovery for Other Damages
Damage awards are generally taxable if they were intended to compensate the taxpayer as follows: compensation for lost wages or profits; punitive damages, even if they relate to a physical injury or sickness; amounts received in settlement of pension rights when the taxpayer did not contribute to the plan; interest on any award; damages for patent or copyright infringement, breach of contract, or interference with business operations; and back pay and damages for emotional distress received under Title VII of the Civil Rights Act of 1964.
If a taxpayer receives an award that is tax-free, he is not entitled to a deduction for legal fees expended in obtaining the award. On the other hand, if the award is fully taxable, then all of the litigation costs are deductible. An award that is partially taxable and partially tax-free will result in deductible legal fees only to the extent they can be attributed to the taxable award.
If an attorney was paid a contingent fee from a taxable award, the taxpayer generally must report the entire award as income. He will only be able to deduct the fee as a miscellaneous itemized deduction subject to a 2 percent adjusted income floor.
Copyright 2012 LexisNexis, a division of Reed Elsevier Inc.