In general, damages received as a result of a settlement or judgment are taxable to the recipient. 1944)).įor a recipient of a settlement amount, the origin- of- the- claim test determines whether the payment is taxable or nontaxable and, if taxable, whether ordinary or capital gain treatment is appropriate. In applying the origin- of- the- claim test, some courts have asked the question 'In lieu of what were the damages awarded?' to determine the proper characterization (see, e.g., Raytheon Prod. In general, the proper tax treatment of a recovery or payment from a settlement or judgment is determined by the origin of the claim.

While the federal tax treatment does not depend on whether litigation is concluded by a judgment or order or by agreement of the parties, generally more flexibility exists in clarifying the proper tax characterization of an item when litigation is concluded by settlement rather than judgment, because of a greater ability to clearly reflect the intent of the parties and the purpose for the payment in a settlement agreement. Taxpayers should consider these issues during a litigation or arbitration process.

In general, the taxpayer has the burden of proof for the tax treatment and characterization of a litigation payment, which generally will be determined by the language found in the underlying litigation documents, such as pleadings or a judgment or settlement agreement.

The federal tax implications of a settlement or judgment, which can be significant, often are overlooked.įor both the payer and the recipient, the terms of a settlement or judgment may affect whether a payment is deductible or nondeductible, taxable or nontaxable, and its character (i.e., capital or ordinary). During the normal course of business, a taxpayer may find itself the recipient or payer of a settlement or judgment as a result of litigation or arbitration.

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