When a plaintiff and a defendant enter into a settlement of a tort action, the tax consequences of the settlement will depend upon whether the damages are allocated in the settlement agreement. In other words, the key question is whether the plaintiff and the defendant have set forth the amount that is to be paid for the plaintiff's pain and suffering, past and future medical expenses, or punitive damages.
A settlement agreement should set forth the amount that is allocated for a plaintiff's personal or physical injuries, such as pain and suffering or medical expenses, and the amount that is allocated for the plaintiff's non-physical injuries, such as lost wages or lost profits. The plaintiff's personal or physical injuries are generally not taxable to the plaintiff. The plaintiff's non-physical injuries are generally taxable to the plaintiff. The settlement agreement should also allocate amounts that are paid for punitive damages because punitive damages are generally taxable to the plaintiff.
If a settlement agreement includes damages for past and future medical expenses, the agreement should allocate the past medical expenses and the future medical expenses. If the medical expenses are not allocated, a plaintiff may not be entitled to deduct past medical expenses on his or her current income tax return or to deduct future medical expenses on his or her future income tax returns.
If a plaintiff has been awarded prejudgment interest under a settlement agreement, the agreement should contain an allocation for the interest. Although prejudgment interest is generally taxable to a plaintiff, a defendant may be entitled to deduct the interest on his or her income tax return.
If a settlement agreement does not allocate a plaintiff's damages in a tort action, a court will determine the nature of the plaintiff's claim and the intent of the defendant in agreeing to pay damages to the plaintiff. The plaintiff's complaint will be examined in order to determine the type of damages that have been awarded to the plaintiff. The court and the Internal Revenue Service (IRS) will generally allocate the damages in the same ratio as the damages were alleged in the plaintiff's complaint.
If a settlement agreement does not allocate a plaintiff's damages in a tort action, the plaintiff has the burden of proving how much of his or her damages were awarded for physical injuries and how much were awarded for punitive damages. If a settlement agreement allocates the plaintiff's damages, the IRS will generally recognize the allocation unless it considers the allocation to be unreasonable. If the IRS considers the allocation to be unreasonable, the plaintiff has the burden of substantiating the allocation. If the plaintiff does not meet that burden, all of the plaintiff's damages will be included in the plaintiff's gross income.
When a court has approved a settlement agreement, the IRS may look more favorably on the allocation of damages in the agreement. However, the allocation of damages is not binding on the IRS.
Copyright 2014 LexisNexis, a division of Reed Elsevier Inc.