Attorneys representing clients in legal actions often focus solely on winning a recovery and do not necessarily factor in the tax treatment of that recovery. This can be a mistake because taxes can seriously erode a legal victory. Unfortunately, the rules governing the tax treatment of awards to individuals are complex and not easy to apply in certain situations. Here are some of the issues impacting the tax treatment of damages, including some recent developments.
General Rules
Damages may be partially or wholly taxable, depending on the nature of the damages and the claim to which they relate. Damages are taxable unless they are for physical personal injury or illness (Code Sec. 104(a)(2)). Damages for such injuries as discrimination, injury to reputation, or payments for lost wages (e.g., back pay) are taxable. Punitive damages, regardless of the nature of the claim, are always taxable.
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