Federal Income Tax Consequences of Settlements and Judgments-part I: Plaintiffs

• Publication year: 1986
• Pages: 38
• Citation: Vol. 15 No. 1 Pg. 38

15 Colo.Law. 38 Colorado Lawyer 1986.

1986, January, Pg. 38. Federal Income Tax Consequences of Settlements and Judgments-Part I: Plaintiffs

Vol. 15, No. 1, Pg. 38

Federal Income Tax Consequences of Settlements and Judgments---Part I: Plaintiffs

by Mary B. Roudebush

When a plaintiff settles a suit or wins a judgment in civil litigation, the recovery may be subject to federal income taxes. Whether it is in fact subject to such taxes depends upon the nature and origin of the recovery. If federal income taxes are imposed upon the recovery, the plaintiff's net benefit from the recovery may be reduced substantially. Therefore, the plaintiff's attorney must understand whether the recovery is subject to federal income taxes and, if so, communicate that fact to the plaintiff to prevent any subsequent disappointment when part of the recovery must be used to pay federal income taxes.(fn1)

Knowledge about the federal income tax consequences of a settlement or judgment is also critical for the defendant's attorney. The defendant's effective cost to pay a settlement or judgment is reduced to the extent the defendant benefits from deducting such payment in computing federal income taxes.(fn2) The defendant's attorney may also be able to use the nontaxability of the plaintiff's recovery to convince the plaintiff to accept less in a settlement or the jury to award less in a judgment.(fn3)

Part I of this article describes the federal income tax consequences of recoveries by plaintiffs. Part II, which will appear in the February issue in this space, will describe the federal income tax consequences of payments by defendants. To provide the best possible representation for the client, attorneys should be familiar with the tax consequences of settlements and judgments for both the plaintiff and the defendant.

Personal Injury Recoveries

The Compensatory Portion:

By statute, federal income taxes are not imposed upon a plaintiff's recovery of compensatory damages for a personal injury.(fn4) This statutory exclusion from taxation applies (1) whether the personal injury is physical or mental or both; (2) whether the recovery is received as a lump sum or in installments; and (3) whether the recovery results from a settlement or a judgment.(fn5)

For example, when an individual was struck by a bus and seriously injured, the settlement he received for medical expenses and for pain and suffering was not taxable pursuant to this statute.(fn6) In addition, the jury prevented him from working, and the portion of his recovery measured by lost wages was not taxable.(fn7) Thus, the entire settlement for compensatory damages was not taxable because the damages resulted from a personal injury.

However, if a plaintiff deducts the medical expenses resulting from a personal injury in the plaintiff's federal income tax return and recovers those expenses in a subsequent taxable year, the portion recovered may have to be included in income. If the plaintiff received a tax benefit (i.e., a reduction in taxes) from the deduction for the expenses in the prior year, the recovery for such expenses is taxed in the later year when received.(fn8)

A recovery for compensatory damages for a civil rights violation generally is treated as a recovery for a personal injury and so is not taxed. However, if the recovery represents an award for back pay to replace wages that would have been earned but for the discrimination, the recovery constitutes wages and is subject to federal income taxes.(fn9)

A recovery which compensates for damage to an individual's personal reputation is not taxable because it is a recovery for a personal injury.(fn10) A personal reputation can be damaged by libel or slander. For example, a libelous newspaper article can damage "personal reputation, social standing, and family relationships." The compensatory damages received as a result of the article would not be taxable.(fn11)

While a recovery which compensates for damage to an individual's personal reputation is not taxable, a recovery for damages to an individual's business or professional reputation generally is taxable.(fn12) However, two recent cases have blurred any distinction between personal and business reputation.(fn13) In one of the cases, Roemer v. Commissioner,(fn14) the court did not make a distinction between damage to the plaintiff's personal and business reputation. Instead, the court held that the plaintiff's recovery was for a personal injury and therefore was not taxable because defamation was treated as a personal injury---a tort claim---under state law. The personal injury involved was the denial of a license to...