Court Judgments 101
Court judgments are the result of a judicial decision, which is a decision made by a court, in either the Civil or Criminal system. The decision may involve the resolution of a dispute between two or more parties, or a criminal finding against an individual or entity. Judgements generally fall under two main categories: money judgements and equitable judgements. Money judgements require payment of a specific amount of money, while equitable judgements are based on the idea of restoring balance to the situation, and these types of judgements are wide-ranging.
The party who loses a court case is identified as the defendant, while the winning party is identified as the plaintiff. The judgement that is rendered by the court is enforceable by law; however, appeals are another option for defendants who wish to challenge the decision of the court.
Judgements are rendered by different courts , with the rules for their use varying slightly. For example, judgements in Civil court typically award a monetary value to be paid by the defendant to the plaintiff. The size of the award is based upon the merits of the case, and is dependent on the jurisdiction in which the judgement is awarded. For instance, one state may have very strict rules against awarding large sums of money for damages, while others, such as Florida, take a much more lenient stance on these issues. If a defendant does not pay the damages awarded, the plaintiff can compel the defendant to do so by filing a motion with the court.
Judgements rendered in criminal court differ in that there are no monetary awards involved. Instead, criminal judgements may order the defendant to pay restitution to victims, or repay the costs of incarceration or probation. The court may also award community service or permit parole as part of a criminal judgement.
What Counts as Taxable Income?
In determining whether a court judgment is taxable, it is essential to first understand the general criteria used by the Internal Revenue Service (IRS) and other tax authorities in establishing what constitutes taxable income. According to IRS Publication 525, the general equation for taxable income is "income received or accrued – exclusions = taxable income."
Consequently, a natural starting point to determine the tax implications of a particular award is a careful review of the pertinent tax exclusion statutes. The most commonly relied upon tax exclusion provisions include Internal Revenue Code sections 104(a)(2) and 104(a)(4)(B).
Section 104(a)(2) provides an exclusion from gross income for damages received either through judgment or settlement due to physical, emotional or mental injury or sickness, or through wrongful death; generally speaking, however, punitive damages are taxable. Subsection (a)(4)(B) of section 104 seeks to exclude from gross income certain damages received from state judgments with respect to certain employees including those who are soldiers, sailors, airmen and coast guardsmen.
Exclusions under subsections (a)(2) and (a)(4)(B) only apply if the underlying litigation (e.g., personal injury or wrongful death litigation) occurred prior to the enactment of the Tort Reform Act Amendments of 1996 (Pub. L. 104-19). The Tort Reform Act Amendments (27 U.S.C.A. § 104) included a provision that disallows the exclusion of punitive damages from taxable income for awards identifying taxable compensatory damages and punitive damages separately. In addition, the Act added additional language (27 U.S.C.A. § 104(a)) which, essentially, makes taxable "damages received [by a federal employee for] personal injuries or sickness attributable to such employee’s service in the line of duty as a member of a uniformed service."
Because the statutory exclusions have been held not to apply to awards received after the enactment of the Tort Reform Act Amendments, it is necessary to look to the judicial constructions of section 104 for guidance in this area. Like the statutory provisions, the case law is not uniform. For instance, the United States Court of Appeals for the Ninth Circuit in Onsi v. McHugh held that the Tort Reform Act Amendments did not apply in circumstances wherein the jury could not separate components of a compensatory damage award into past non-taxable and future taxable damages due to vagueness, but instead awarded a flat sum.
On the other hand, in Smith v. Commissioner of Internal Revenue, the Tax Court held that an award for back wages which were subject to income taxation were not included in the exclusion provided by section 104(a)(2) because the award was for lost wages and not loss of earning capacity. Furthermore, in Hatter v. Commissioner of Internal Revenue, the Tax Court held that an award which was a single lump-sum award for physical injury or sickness was allocated for tax purposes to the three preceding tax years in amounts proportionate to the compensation for lost profits in each of those years. The United States Court of Appeals for the Fifth Circuit, similar to the Tax Court in Hatter, found that an award of money damages in a lawsuit for discrimination suffered by a federal employee was to be allocated to the years in which emotional distress was experienced.
When Do Court Judgments Become Taxable?
Under federal tax law, there are two guiding principles by which to determine whether court judgments are considered taxable income. The first is that damages for lost wages or profits are considered taxable. The second is that damages for physical injuries or sickness are not considered taxable. (26 C.F.R. § 1.61-3(a)). However, damages that are meant to compensate for non-physical, yet personal, damages are not considered taxable under federal law.
Nevertheless, there are exceptions to these rules. For example, if a plaintiff’s claim for fraudulent misrepresentation compensation does not involve a specific physical injury (beyond normal emotional distress), the judgment may be considered taxable even though it is a "non-physical" injury. Also, a compensatory damages award that is intended to make up for loss of earnings can be treated as ordinary income that is subject to taxation. In the case of Gallagher v. Comm’r, 31 T.C. 230, 240 (1958), the court ruled "the evidence shows that the damages awarded as compensation for lost profits were made specifically for the loss of income over a period of time." The verdict also called for payment of taxes on behalf of the plaintiff as part of the award, meaning that the money would count as taxable income. Therefore, the court affirmed reclassification of the damages as ordinary income. (Gallagher at 246).
In other cases, courts have held that, even when the verdict calls for payment of damages for physical injury, courts treat the payments as ordinary income. For example, in Bullock v. Comm’r, 79 T.C. 498, 505 (1982), the court stated that, because damages for lost pay are classified as ordinary income, but damages for physical pain and suffering are not (properly) taxed as ordinary income, therefore "all of the payments in question would be taxable" even when physical injury was a consideration.
Courts also consider an award for slander when determining whether it should be taxed as ordinary income. (26 C.F.R. § 1.61-24). In the case of Gilbert v. Comm’r, 74 T.C. 1190, 1195 (1980), the court ruled that damages for slander were taxable "because such damages ordinarily result in a loss of current or future earning capacity and are very much like damages for loss of wages or profits."
These cases show how courts will go to great length to classify damages in specific ways in order to determine whether a judgment will be taxed as ordinary income. Nevertheless, there are times when a plaintiff receives a judgment for physical injuries, only to find that those injuries are still taxed as ordinary income.
Exceptions to Taxable Court Judgments
While most court judgments are taxable, there are some types of court judgments that are non-taxable or that have specific exemptions. For example:
- Labor and employment law related court judgments, such as those for unpaid minimum wage or overtime, are not subject to taxes. The idea behind this exemption is that employees ought to be compensated for all hours that they work, not just those that generate commissions or other bonuses.
- Money paid as damages for personal injury is not taxable. The IRS recognizes that this type of injury cannot be reversed and is not the employee’s fault. Thus, there is no tax liability created from this financial loss.
- Punitive damages are not taxable. This is true even if these damages were awarded in a labor or employment law court case. This is rational on the same grounds that personal injury damages are not taxable: the damages are intended to compensate for harm done and punishing the company that caused the harm is not something a court can reverse.
Filing Court Judgments on Tax Returns
When it comes to taxes, the onus is on taxpayers to determine how the receipt of funds is taxed. What’s more, the IRS treats compensatory damages and punitive damages differently. Generally, compensatory damages are tied to actual losses — for example, lost wages or property damage. In contrast, punitive damages are imposed by courts not for a plaintiff’s actual losses but as punishment to a defendant for wrongdoing. Any awards deemed to be punitive are generally taxable.
If you award someone damages after an accident, that’s unlikely to be a taxable punitive damages award. However, even if you feel that you’ve awarded damages compensatory in nature to a plaintiff and not punitive in nature; the IRS may disagree. So, if you’re thinking about not reporting a verdict, because you believe it is not taxable to the plaintiff, you should think again before you fail to report.
Compensatory damages (not punitive) may sometimes fall under the personal physical injury or sickness tax exclusion. In general, amounts received as compensation for injuries or sicknesses are not included in gross income under Code Sec. 104(a)(2). However, since a June 9, 1997, revision to the tax law, the exclusion does not apply to punitive damages, to interest awards, or to damages that are not on account of a personal physical injury or physical sickness.
IRS reporting obligations
If you obtain a court judgment in your favor, the adverse party will usually be required to issue you a Form 1099 to report the judgment (other than interest, which may be reported separately). The same rule applies to settlements. Thus, if a court awards you a judgment or if a defendant in a case settles a lawsuit with you and is obligated to pay you certain funds, the defendant (or the insurer or another party liable for the payment) will usually be required to issue a Form 1099 or other reporting document to you, even if your claim is based in part on personal physical injury or sickness . This is so even if you believe that the amount that you are receiving is excludable from income under Code Sec. 104(a)(2) because your claim is based on compensatory damages for injuries or sickness resulting in physical injuries.
Information returns, generally, are informational statements concerning payments, payments made, or other information, that must be filed with the IRS and furnished to persons of whom they are required. Generally, these statements may be filed on paper or electronically. However, if the requirement to file them applies to smaller amounts and there are numerous filers that must file them, the IRS may issue an order requiring these statements to be filed electronically. Under its regulations, the IRS may require that statements be filed electronically if the aggregate information required to be reported to it is more than 250 papers, cards, etc., or if aggregate information reported on such papers, cards, etc., is more than 200,000 documents, statements, etc. Specifically, the IRS requires informational returns concerning payments of interest and dividends; substitute payments in lieu of dividends and interest; patronage dividends; royalty payments; other fixed or determinable gains, profits and income (except wages); taxable pensions, annuities, and other deferred income; payments of $600 or more (directly related to a trade or business) to a lawyer or law firm; gambling winnings; substitute payments in lieu of dividends, interest or tax-exempt interest; stock redemption; acquisitions or dispositions of controlled property; real estate transactions; certain variations in the cost basis of stock; substantial imputed income from life insurance; market discount on bonds; and discharge of indebtedness.
The Form 1099 ordinarily is required to be filed with the IRS within 30 days after the close of the calendar year during which the payments are made. However, if you file a Form 1099, you generally must furnish the recipient a copy of the form no later than January 31 of the following calendar year.
Taxes for Settlements vs. Court Judgments
The taxation of settlements vs. court judgments is an important topic that is frequently misunderstood, even by the most experienced tax professionals. For this reason, it is often best to consult with an experienced tax advisor before concluding that the settlement of a particular claim will be subject to tax.
The taxability of a settlement and the taxation of a judgment are generally treated the same under federal law. This is because the tax provisions governing such amounts are strictly statutory. For example, under Internal Revenue Code (IRC) § 61(a), income is broadly defined to include "all income from whatever source derived." As a general rule, all payments received in settlement of litigation are considered taxable, except amounts specifically excluded from income by statute. See IRC § 741. In cases involving the acquisition or sale of property (such as legal malpractice), damages for breach of the right of quiet enjoyment are generally not taxable under the "return of capital" doctrine. These cases involve the return of an injured party back to the position it would have been in but for the conduct of the wrongdoer.
In addressing specific cases involving the taxation of lawsuits, the courts have developed strikingly similar rules for settlements and judgments. In First Chicago NBD Corp. v. Comm’r, 200 F.3d 994 (6th Cir., 1999), the court emphasized the broad reading of "income," stating: "Although the parties may characterize a cash award according to any number of labels, the proper characterization for tax purposes depends on what the recipient actually receives and the nature of the claim that gave rise to the award." Id. at 1003. First Chicago involved a series of fee-award litigations stemming from the company’s success against a lender. The bank sought fees, but the district court had only awarded fees to the bank’s attorneys and not the bank. The awards were challenging enough to the company that it fought vigorously to recover from the bank. While the company did not receive this "award" until appellate fees were approved, for tax purposes they were "one and the same." Thus, the bank was taxed on a series of interim awards, without regard to whether the bank "prevailed" on appeal. Id. at 1005.
This case demonstrates that the transfer of any amount in satisfaction of a claim will be taxable regardless of how the parties characterize the payment. The court looked at two factors to evaluate the nature of the recovery: first, whether the transferable asset had attributes of income; and second, whether the underlying claim giving rise to the transfer was transformed into a claim for money damages. Id.
In Farimura v. United States, 721 F.2d 23, 27 (9th Cir., 1983), the court emphasized the importance of the origin of the claim. For example, proceeds from a lawsuit challenging the government’s strict liability for aircraft design defaults were taxable. Proceeds from a lawsuit challenging a government regulation limiting travel expenses to officers of the company were not. The claims arose from a violation of Title 10 U.S.C. § 1423(a), which set a maximum amount of salary for certain military brass. The lump-sum award was not deemed taxable because the source of the claim arose directly from the personal injury to the officer.
Thus, the rule that sets the taxability of an award is the origin of the claim, not the nature of the recovery. Unlike settlements, court judgments have a special ability to convert a nontaxable injury to a taxable "collection." This was demonstrated in Schlude v. Commissioner of Internal Revenue, 24 T.C. 128, 133 (1955), in which the court stated: "A judgment of . . . court . . . is a "constructive receipt" of the amount thereof by the taxpayer. Even though not actually collected, the amount is within his control and can only be held by the court or the taxpayer. It is available to him.[3] Under these circumstances, with regard to the damages for the taking of the property, they must be considered, for tax purposes, as having had their origin in the condemnation proceeding. That proceeding had its genesis in the expropriatory acts of respondent." Schulde, 24 T.C. at 133 (taxing compensatory damages).
Real World Examples – IRS Guidance
Numerous real-life cases are illustrative of the Court’s position that court judgments are taxable. In United States v. Galletti, 541 U.S. 114, 124 (2004), the United States Supreme Court considered a case where the IRS sued members of a bankrupt partnership to collect his share of unpaid employment taxes for the period before their bankruptcy. The IRS filed a notice of federal tax lien in 1994, and the partnership filed for bankruptcy in 1996. A distribution from the bankruptcy estate was made in 1997 for the remaining tax liability, but in 2002 the Bankruptcy Court released the lien.
The relevant revenue ruling describing the taxation of a jury award is Rev. Rul. 75-358, 1975-2 C.B. 19. Although the ruling concluded that the award was taxable, it is nevertheless informative about the IRS’ treatment of this judicial award. The IRS compared the circumstances of this case with the speculation about whether a damage award stemming from a product liability claim would be taxable, as opposed to an award stemming from a defamation claim, with the conclusion that a product liability damage award would be taxable. The IRS reasoned that:
"a damage award received from a verdict in a defamation suit is taxable, just as is a damage award received from the verdict in a products liability suit." The basic rationale for the positions expressed in the private letter rulings cited [in the ruling] is that amounts received in damages or in settlements for defamation of character derive from the plaintiff’s name and reputation and, in essence, are for the loss of an asset. Amounts received in damages or in settlements for personal injury derive from the plaintiff’s personal injuries (not the damage done to him or his property) and, in essence, are for the loss of an asset." Rev. Rul. 75-358.
In Harris v. Commissioner, 68 T.C. 422, 429 (1977), the taxpayer received a "damage award as compensation for compensation injury . . . which is included in gross income. Our decision in Mauldin v. Commissioner[1] . . . is controlling." The Tax Court stressed that the taxpayer’s damages and treasury regulations "make specific mention of an exception to the ‘generally applicable’ non-taxable awards by referring only to an award of damages on account of a ‘personal, physical injury or physical sickness." (Citing Section 104(a)(2) and Treas. Reg. § 1.104-1(c)(1)). In the final analysis, the Tax Court concluded that the damages received by taxpayer in Harris represented ordinary income, and taxpayer, therefore, was not entitled to the "non-taxable exception." Harris v. Commissioner, 68 T.C. at 429.
In the end, when the IRS challenges an award based on the allegation that it is taxable, the IRS has the burden of proof to show that the award is taxable. See United States v. Roth, 31 AFTR 2d (P-H) 1631, 1962-1 (1955). However, any argument that the amount received should be excludable from gross income will be the responsibility of the taxpayer. See Harris v. Commissioner, 68 T.C. at 429. The IRS has well-defined guidelines to assist taxpayers in knowing when a court award is taxable. Where the payment is made as the result of an award from the court the amount will be taxable pursuant to United States v. Huber, 603 F.2d 342 (7th Cir. 1979) and Davison v. United States, 99-1 USTC ¶50,407 (E.D.Pa. 1999).
Retain a Tax Professional
Consulting with a tax professional or attorney can be an essential step for those uncertain about the taxability of the settlement, particularly when the amount in question is substantial. While some individuals may choose to rely on online resources or anecdotes to make their determination, the taxation of a court judgment is ultimately a question of law, and requires a more in-depth examination than that available though a basic online search would suggest. Additionally, there are many factors that could lead to different tax treatments of the same core sum of money. For example, a court may consider child support to be income that’s taxable to a spouse upon receipt, while that same amount may not be taxable at all to the parent who must pay child support. A separately calculated marital property award, on the other hand, is generally excluded from taxable income . Because of this nuanced approach to the taxability of marital awards, it is wise for an individual with questions to work with an experienced tax attorney to determine their rights and obligations. When choosing a tax professional, start with trusted sources, such as your divorce attorney or a trusted friend or family member. Such a referral is likely to provide you with a leg up in the hiring process, but any professional worth hiring should be able to provide you with several references, reviews or other positive markers. A live interview (it does not have to be in-person) is also a good idea. When it comes to matters related to the taxability of a court judgment, it is very easy to end up on the wrong side of the coin. Court-awarded amounts can also have significant prize winnings rules attached, for example, awarding the recipient a windfall in the way of an unexpected tax bill. Don’t put yourself at risk—work with a reliable tax professional to make the right choice.