Are Punitive Damages Included in Gross Income?
Understand the tax treatment of punitive damages. This guide clarifies why these awards are typically included in gross income and how they differ from compensation.
When a lawsuit concludes with a monetary award, the recipient might not realize the funds could have tax implications. Punitive damages, a specific type of award, have their own tax rules. These damages are not meant to compensate a person for a loss but are awarded to punish a defendant for egregious conduct. Understanding how the Internal Revenue Service (IRS) treats these payments is part of managing the financial outcome of a legal dispute.
The General Rule for Taxing Lawsuit Awards
The IRS’s approach to taxing lawsuit proceeds is guided by the “origin of the claim” doctrine. This principle means the tax treatment of a settlement depends on what the payment was intended to replace. If an award compensates for something that would have been taxable income, like lost wages, the award itself is taxable. Internal Revenue Code (IRC) Section 61 states that all income is taxable from any source unless a specific exemption exists.
A primary exemption is detailed in IRC Section 104, which excludes damages received for personal physical injuries or physical sickness from gross income. This means money awarded for medical bills or pain and suffering directly resulting from a physical injury is not taxed. However, this exclusion is narrow, as awards for non-physical injuries like emotional distress are considered taxable income unless the distress is a direct result of a physical injury.
Compensatory damages aim to make a plaintiff “whole” by reimbursing for a loss, while punitive damages serve to punish the defendant. This distinction places them in separate categories for tax purposes. The settlement agreement is an important document, as the IRS often looks to the stated purpose of the funds within it to determine taxability.
Tax Treatment of Punitive Damages
Punitive damages are almost always included in gross income and are subject to taxation. The IRS views these awards as a financial windfall rather than compensation for a loss, so the money is treated as ordinary income. This rule applies even if the underlying lawsuit was for a personal physical injury where the compensatory portion of the award is tax-free.
A narrow exception exists for certain wrongful death cases. Under the tax code, punitive damages may be excluded from income if the relevant state law in effect on September 13, 1995, stipulated that only punitive damages could be awarded in such lawsuits. If the state law allowed for any other type of damages, this exception does not apply.
Given the specific and dated nature of this provision, the vast majority of punitive damage awards today are fully taxable. It is also worth noting that any interest paid on a settlement, including on punitive damages, is taxable as interest income. This means recipients should be prepared for a significant tax liability on these types of awards.
Reporting Punitive Damages to the IRS
The payer of punitive damages is required to issue a Form 1099-MISC, Miscellaneous Information, to the recipient if the amount is $600 or more. This form serves as an official record for both the recipient and the IRS, documenting the income paid.
The punitive damages amount is reported in Box 3, “Other income,” on the Form 1099-MISC. The taxpayer must report this amount on Schedule 1 (Form 1040), Additional Income and Adjustments to Income. The total from Schedule 1 is then transferred to the main Form 1040 and included in the calculation of total gross income.
It is important for taxpayers to ensure the amount reported on their tax return matches the amount shown on the Form 1099-MISC, as a discrepancy can trigger an inquiry from the IRS. If a recipient believes the amount is incorrect or that a portion of the award should not be taxable, they should address it with the payer and may need to provide an explanation on their tax return.
Deductibility of Related Legal Fees
Whether the legal fees paid to obtain a taxable award can be deducted has changed due to the Tax Cuts and Jobs Act of 2017 (TCJA). Before the TCJA, legal fees for securing a taxable award could be claimed as a miscellaneous itemized deduction.
The TCJA suspended miscellaneous itemized deductions for tax years 2018 through 2025, meaning associated legal fees are not deductible for most individuals receiving punitive damages. A taxpayer is taxed on the gross amount of the award, including the portion paid directly to their attorney. This can result in a tax liability on money the individual never personally received.
A limited exception exists for legal fees in certain unlawful discrimination lawsuits, which may be eligible for an “above-the-line” deduction. This means the taxpayer does not need to itemize to claim it. This exception is not broadly applicable to all lawsuits that might result in punitive damages.