Entering into litigation is a stressful time for any business owner or CFO. While possible damages or a settlement are of utmost concern, there will also be consequences come tax time. Even your legal expenses can play a role in determining how best to minimize the tax implications of legal action. It’s important that you start planning with a tax advisor as early in the process as possible.

Taxation of Settlements and Payments

A fundamental principle of U.S. tax law is that all income is taxable, regardless of its source, unless it is specifically exempt by a section of the Internal Revenue Code (IRC). For individual taxpayers, one such exemption is found in IRC Section 104, which says that damages a taxpayer receives on account of personal physical injuries or sickness do not need to be included as part of that taxpayer’s gross income.

Note, however, that this exemption does not apply to punitive damages a court may award. If your company is the defendant in a personal injury case, knowing the potential tax treatment a plaintiff can expect is often helpful when discussing a possible settlement.

Of course, most commercial litigation involves issues other than physical injuries or sickness, and the proceeds from those cases involving business entities are usually taxable. In such cases, the critical issue is whether those proceeds are taxed as ordinary income or as a capital gain—a distinction that will have a major financial impact for a successful plaintiff.

The central question taxing authorities and courts consider when determining the tax treatment of a settlement or award is, “in lieu of what were the damages awarded?” In other words, what type of loss is the payment intended to replace?

Consider, for example, a breach of contract or intellectual property dispute. If the proceeds of such an action are intended to reimburse the plaintiff for lost profits, the award would be taxed as ordinary income. On the other hand, if the payment is actually meant to reimburse the company for damages to a capital asset, such as loss of goodwill or diminished value of its capital investment, the proceeds could be treated as a nontaxable return of capital. Any proceeds that exceed the company’s basis in that asset would be taxed as a capital gain.

Note that it does not matter how the case is settled—that is, whether it is resolved through a court judgment, negotiated settlement, arbitration, or other means. What matters is how the proceeds are characterized. To determine this, taxing agencies will look at the text of the court award or settlement agreement, but the primary evidence they consider is the wording of the original complaint or claim itself. This is why it is so important that management and legal counsel involve their tax team as early as possible whenever they consider legal action.

Deductibility of Expenses

For individual taxpayers, the Tax Cuts and Jobs Act (TCJA) of 2017 eliminated most miscellaneous personal deductions—including the deductions for legal fees—until 2026. The loss of this deduction can create tax issues when legal fees are paid under a contingency arrangement. The taxpayer will be taxed on the full settlement but will not be able to deduct the portion retained by the attorney as a contingent fee. However, the TCJA made an exception to allow deductions for personal legal fees that individuals incur in employment cases involving whistleblowing or claims of unlawful discrimination.

For businesses, on the other hand, attorneys’ fees and legal costs are generally considered an ordinary and necessary business expense, making them deductible. An important exception, which was also part of the TCJA, applies to sexual harassment or sexual abuse settlements that include nondisclosure agreements. Any payments a company makes in such cases, and attorneys’ fees related to such a settlement, are specifically not deductible.

From the tax code, to court decisions, to your unique business situation, determining the best course of action when dealing with litigation-related taxation requires full breadth of knowledge and expertise. Consult early on with qualified advisors to minimize the disruption to your business and maximize savings.

Dembo Jones’ team of tax advisors have experience with all facets of business litigation, including forensic accounting, valuation, calculation, and ensuring your company can thrive following the outcome. Contact us today.