The tax treatment of amounts received pursuant to a judgment or settlement is determined by reference to the underlying claim which the lawsuit seeks to redress. In addition, where the claimant is seeking capital gain treatment for the recovery, a sale or exchange must have occurred. With these principles in mind, the first question that arises is the tax treatment of any recovery that a taxpayer might receive.
Damages awarded for lost profits are taxed as ordinary income.. Damages awarded for the loss of capital assets are taxed as capital gain. If, however, the plaintiff derived profits from the stolen assets, the portion of the recovery attributable to lost profits would be taxed as ordinary income, because it would represent a recovery of lost profits.
The underlying claim for any recovery a taxpayer may succeed in obtaining from a defendant for damage to the business reputation is compensation for harm to goodwill. If your company has a basis in its goodwill, a portion of the recovery would be nontaxable as a return of capital. The balance will be taxable as capital gain.
Physical personal injury recoveries are nontaxable under the income tax laws. The rationale behind this result is that a taxpayer should not be taxed on the receipt of money damages which are merely intended to make him whole from physical injury. Since libel of an individual is not a physical personal injury, any recovery for libel is subject to taxation. Punitive damages that you may recover are also taxable.
The drafter of the complaint needs to be mindful the tax treatment of recoveries, in order to take advantage of the opportunities presented for minimizing the tax liability associated with the receipt of the contemplated recovery.