For the purpose of tax treatment, awards and settlements can be classified into two distinct groups, viz. claims arising on account of physical injury and those resulting from non-physical injury. Each of these claims can further be classified into the following three categories,
- Punitive damages
- Emotional damages
- Actual damages
Punitive damages are awarded to the plaintiff in order to punish a defendant and forestall others from committing similar acts. However, these are contingent on the plaintiff proving the desirability or the necessity of awarding the same. Typically, punitive damages are awarded when the offense is committed knowingly, deliberately or on account of negligent or fraudulent behavior. The amount, that is designated for punitive damages, is not excluded from taxable income even if the amount was received in lieu of physical injury.
Actual damages are losses that can be attributed to the defendant's wrongdoing and can be measured in quantitative terms. In other words, they are real damages. Compensatory damages are different from punitive damages since the money, that is awarded in lieu of compensatory damage, is meant to compensate losses on account of actual damage as well as distress like pain and suffering that cannot be easily quantified.
As far as taxability of compensatory damages is concerned, the facts and circumstances of each lawsuit settlement must be considered to determine whether these amounts can be excluded from taxable income. For instance, compensatory damages for lost wages or income lost on account of physical injury are not subject to tax. However, an amount that is awarded for emotional damage is taxed if the stress is not on account of physical injury inflicted by the defendant. Again, settlement awarded for mental stress on account of physical injury is not taxable.
All income received by individuals is taxable and exemption is offered only in certain cases. According to the 1996 amendment added to IRC section 104(a)(2), damages or settlements offered on account of 'personal physical injuries or physical sickness' can be excluded from taxation. All other settlements, that haven't been awarded for any kind of 'physical injury or sickness' are taxable. Damages offered for 'emotional distress', not resulting from physical injury are taxable. Settlement for punitive damages in particular, cannot be excluded from gross income and are therefore taxable.
In general, settlement received as a compensation for physical injury, viz. dismemberment, disfigurement or accidental death, and distress on account of physical injury is exempt from tax. However, as mentioned earlier, amount that is received in lieu of punitive damages related to physical injury is taxable. This is true irrespective of whether the settlement is categorized as a court verdict or an out of court settlement.
If the settlement is compensation for lost business, the amount is taxable assuming that the lost income was originally taxable. For instance, in case of patent infringement, the amount awarded for compensatory damages is taxable if the income from patents was originally subject to business and occupation (B&O) tax.
Sometimes, it may be possible to break down the amount of taxable lawsuit settlement(s) into annuity payments that are received over a span of many months. Unlike lump sum payments, annuities are tax free structured settlements and thus are effective in reducing the tax burden. To conclude, only settlements resulting from physical injury or sickness are non-taxable; all other types of settlements are taxable. Still, given the complexity of the query, it would be prudent to consult an attorney or a tax adviser for further clarification.