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Taxation of Court-Ordered Damages Awards

by Natalie Lorenz, Associate

Question: Do I have to pay taxes on damages I received in a court case?  Answer: It depends on the reason you received the damages.

Damages are not taxable if they are awarded on account of a personal physical injury.  26 U.S.C. 104(a)(2).  Under this test, there are two requirements: first, there must be a physical injury, and second, damages must have been awarded “on account of” that physical injury.

There has been much litigation over what exactly counts as a “physical injury” due in part to the lack of that term’s definition in the Internal Revenue Code.  The only helpful information set forth in the Code is that “emotional distress shall not be treated as a physical injury.”  26 U.S.C. 104(a).

In addition, the meaning of the words “on account of” has also been highly debated.  Helpfully, the United States Supreme Court has ruled that punitive damages are not awarded “on account of” a physical injury, but rather are awarded “on account of” a defendant’s reprehensible conduct.  O'Gilvie v. United States, 519 U.S. 79, 83 (1996).  Therefore, punitive damage awards are always taxable.  Despite this ruling, however, many questions remain regarding whether other damages awards are “on account of” a physical injury.  For example, does the defendant have to cause the physical injury for damages to be “on account of” that injury?  What if the plaintiff is physically injured, and her insurance company wrongfully refuses to cover expenses for her care?  O’Gilvie provides that a physical injury must cause the plaintiff’s damages, but says nothing about whether the defendant must cause the physical injury.

After determining whether damages are taxable, related issues are simpler.  If damages are taxable, so is the portion of the damages paid to an attorney as a contingent fee.  C.I.R. v. Banks, 543 U.S. 426, 436-37 (2005).  If the damages are not taxable, the portion of the damages payable as attorneys’ fees likewise are not subject to tax.  33A Am. Jur. 2d Federal Taxation 13385.

Even if damages are taxable, there is a small silver lining.  The attorneys’ fee portion of the award is tax-deductible at least as a miscellaneous itemized deduction, and may even qualify as an above-the-line deduction in certain circumstances.  Attorneys’ fees are not, however, deductible for alternative minimum tax purposes.  33A Am. Jur. 2d Federal Taxation 13385.  

Mathis, Marifian and Richter recently successfully represented the recipient of a damage award before the IRS.  Our client’s underlying case wherein he won his damage award was based on race discrimination, which normally would not result in physical damages.  However, we successfully argued that a portion of our client’s damages included a physical element because his employer intentionally exposed him to physical health threats unexperienced by his colleagues specifically because of his race.  Therefore, the IRS ruled that a significant part of our client’s damages were not taxable, and awarded him a large refund.

 

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