Are Lawsuit Settlements Deductible?

Tax deductible items are expenses that can be subtracted from adjusted gross income so as to reduce the net taxable income. These allowable deductions are useful to the defendant, who may be forced to make disbursements in favor of the plaintiff, since tax deductible items have the effect of reducing the defendant’s tax burden. Are lawsuit settlements deductible? The answer to this question hinges on the nature of the settlement and the damages awarded to the plaintiff in a court of law.

Basics

Damages or monetary compensation awarded by a court in a civil action, to the plaintiff who has been injured by the action of the defendant, may be punitive or compensatory. The latter is awarded as compensation for actual damages, that can be quantified, as well as compensation for emotional distress. Needless to say, compensation for emotional distress cannot be measured in precise terms. Punitive damages are awarded to the defendant to forestall others from committing similar actions. These are awarded as payment for deliberate actions and negligent or fraudulent behavior. Armed with the knowledge of the classification of damages, we are now in a position to explore deductible lawsuit settlements.

Verifying if Lawsuit Settlements are Deductible

Tax treatment of the payor’s expenditure is as follows:

Tax Treatment for Corporates

The payor’s expenditure may be classified as deductible, capitalized, non-deductible, or non-capitalized expenditure. While the entire amount of deductible expenses can be subtracted from gross income, capitalizing expenses results in writing-off the amount of expenditure over an extended period of time.

Payments that are made by the defendant are tax deductible, provided they can be classified as reasonable, ordinary, and necessary business expenses. Expenses, that are required for producing income, may be tax deductible or the payor may have to capitalize and deduct these costs over time. Payments for wage claims may be deductible by the payor as a business expense unless required by law to be amortized under some other tax rule. Uncontested, non-adversarial, tax-motivated settlements that have been arrived at arm’s length and in good faith will be binding for tax purpose.

At present, the payor is allowed a tax deduction for punitive damages provided these are reasonable, ordinary and necessary business expenses. Tax deduction for punitive expenses has been under fire for a long period of time. The controversy regarding punitive damages stems from the fact that, allowing a tax deduction for punitive damages undermines the role of the same in discouraging and penalizing certain undesirable actions or activities. The Obama administration has introduced as a part of its Federal Budget Proposal for the fiscal year 2010, a measure that calls for the elimination of the deductibility of punitive damage payments incurred on or after December 31, 2010. The opponents of this proposal believe that since tort abuse has escalated, the deductibility of punitive damages as ordinary and necessary business expense is one of the few relief measures available to business owners who may be required to dispense with payments that have no upper limit.

Tax Treatment for Consumers

Tax treatment for consumers may be examined by taking the example of a divorce settlement. The payor is allowed a tax deduction for spousal support, for mortgage payments, insurance premium and real estate taxes paid as alimony in lieu of the home owned by the ex-spouse. Alimony is a tax-deductible expense as far as the payor is concerned while it is taxable income for the payee. Hence, the payee prefers a structured settlement, that reduces income tax payable, as compared to a lump sum. This brings us to the issue of the taxability of lawsuit settlements for a payee.

Hopefully, the above article has answered the query to the satisfaction of the reader. Understanding tax obligations can be complex and it’s definitely not the layman’s cup of tea. Hence, it would be prudent to consult an expert on law and taxation for further details in this regard.

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