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| Tax
Considerations In Tort Litigation |
The income tax
consequences of damages that are awarded in a tort action may have a
significant impact on the parties to the litigation. In most cases, the
tax effect of the damages will depend upon how the damages are
characterized by the parties. Whether the damages are taxable may often
affect the amount that a plaintiff is willing to accept from a
defendant and that the defendant is willing to pay the plaintiff under
a settlement agreement.
The income tax consequences of damages that are awarded in a tort
action may have a significant impact on the parties to the litigation.
In most cases, the tax effect of the damages will depend upon how the
damages are characterized by the parties. Whether the damages are
taxable may often affect the amount that a plaintiff is willing to
accept from a defendant and that the defendant is willing to pay the
plaintiff under a settlement agreement.
The income tax consequences of damages in tort litigation are not
affected by how the litigation is terminated. In other words, the
taxation of those damages does not depend upon whether the litigation
is resolved by a settlement agreement, by an arbitration order, or by a
trial court's judgment on a jury verdict. However, the tax consequences
of a settlement agreement may be an important part of the settlement
negotiation.
A settlement that allows a plaintiff to receive a more favorable tax
treatment may be part of the negotiation process. It may encourage the
plaintiff to accept a lower amount of damages in order to avoid certain
tax consequences. It may also encourage a defendant to pay more damages
if the damages can be deducted by the defendant.
Damages that are received in tort litigation are generally treated like
any other type of income for federal income tax purposes. A taxpayer's
gross income includes income from all sources unless the particular
source is exempt. Damages are defined under the Internal Revenue Code
as an amount that is received through the prosecution of a lawsuit or
through a settlement agreement.
The Internal Revenue Code specifically excludes from a taxpayer's gross
income any damages that are received on account of physical injuries or
sickness. Damages for non-physical injuries, such as damages for
economic losses, are not included within this exemption. Punitive
damages are not included within this exemption, unless the punitive
damages were received as part of a wrongful death action.
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