Getting involved in a legal dispute acquaints you with judgments. Judgments are court orders that require one party to pay another party a certain amount of money as a result of a lawsuit or arbitration. Judgments can have significant financial implications for both the payer and the recipient, especially when it comes to taxes.
Learn how to prevent or minimize tax liability and how judgments affect your taxes with this helpful guide. Whether you are the one paying or receiving the judgment, it helps you make informed decisions and plan accordingly.
The tax consequences of judgments depend on:
- Origin of the Claim
- Identity of the Payer and the Recipient
- Judgment Agreement
Inquisitive? Read on!
1. Origin of the Claim
The origin of the claim refers to the nature and source of the legal dispute that gave rise to the judgment. The origin of the claim determines whether the judgment is taxable or nontaxable to the recipient and whether it is deductible or nondeductible to the payer.
Generally, compensatory judgments are nontaxable to the recipient and nondeductible to the payer. This means that the judgments are intended to restore the recipient to the position they would have been in if the dispute had not occurred, and do not result in any income or expense for tax purposes. For example, judgments for personal injury, physical sickness, or wrongful death are usually nontaxable and nondeductible, as they are meant to compensate the recipient for their medical expenses, pain and suffering, and loss of income.
However, punitive judgments are taxable to the recipient and deductible to the payer. This means that the judgments are intended to punish the payer for their wrongdoing and result in income or expense for tax purposes. For example, judgments for punitive damages, interest, or attorney fees are usually taxable and deductible, as they are meant to deter the payer from repeating their misconduct and reward the recipient for their legal efforts.
There are some exceptions and special rules that apply to certain types of judgments, such as:
- Judgments for emotional distress or mental anguish are taxable to the recipient unless they are attributable to physical injury or physical sickness. The recipient can exclude the amount of the judgment that is used to pay for medical expenses related to emotional distress or mental anguish.
- Judgments for lost profits or lost wages are taxable to the recipient, as they are considered income from the recipient’s trade or business, or the recipient’s employment. The recipient must report the amount of the judgment as income on their tax return, and pay the appropriate taxes, such as income tax, self-employment tax, or payroll tax.
- Judgments for property damage are nontaxable to the recipient unless they exceed the recipient’s basis in the property. The recipient’s basis is the amount they paid for the property, plus any improvements or additions they made to the property. If the judgment exceeds the recipient’s basis, the excess amount is considered a gain from the sale or exchange of the property and is taxable to the recipient. The recipient must report the amount of the gain on their tax return, and pay the appropriate taxes, such as capital gains tax or depreciation recapture tax.
2. Identity of the Payer and the Recipient
Payer and recipient identities allude to the judgment’s parties’ relationships and status. Tax classification of the judgment depends on the payer and beneficiary, such as ordinary, capital, business, or personal.
Typically, ordinary judgments pertain to the payer’s or recipient’s trade or business, while capital judgments pertain to the payer’s or recipient’s investment or personal activities. Ordinary income or expense is subject to a higher tax rate and more constraints than capital income or expense, which impacts the tax treatment of the judgment and the tax rate itself.
If one company owner sues another for breach of contract and wins a judgment for lost profits, that money is ordinary income for the one who gets it and ordinary expense for the one who has to pay it. Judgment payments are taxable as ordinary income, which means as the receiver you must use your marginal tax rates for both income and self-employment taxes. As the payer, you can lower your taxable income and self-employment tax by claiming the judgment as an ordinary expense on Schedule C.
However, if an investor sues another investor for fraud, and receives a judgment for the lost investment, the judgment is characterized as capital income to the recipient and capital expense to the payer. The recipient must report the judgment as a capital gain on their Schedule D, and pay the capital gains tax at a lower rate than the income tax. The payer can deduct the judgment as a capital loss on Schedule D, but only up to $3,000 per year, and carry over the excess amount to the next year.
Note the following exceptions and special rules that apply to certain types of payers and recipients:
- Corporations pay and receive regular judgments regardless of the allegation or behaviour. This is because the corporate income tax does not distinguish between ordinary and capital income or expense.
- A partnership, limited liability company, or trust passes judgments through to its partners, members, or beneficiaries, who must report their share on their tax returns and pay the appropriate taxes, depending on their situation.
- Government, nonprofit, and tax-exempt entities pay or receive judgments that are nontaxable and nondeductible unless the tax statute specifically includes or excludes them. Even if paid or received by a government, nonprofit, or tax-exempt body, interest and penalty judgments are taxable and deductible.
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3. Judgment Agreement
The judgment agreement or terms of the settlement refer to the conditions and stipulations that the parties agree to or that the court orders regarding the payment and the allocation of the judgment. When, how, and whether the judgment is subject to withholding or payment restrictions depends on the settlement or judgment agreement.
Considering all things, the year of the payment or receipt is the correct one to record and account for a lump sum judgment, whereas the year of each instalment payment or receipt is the correct one to do the same for an instalment-paid or received judgment. Nevertheless, specific kinds of settlement or judgment agreements are subject to different regulations and have their own set of restrictions. such as:
- At the time of payment or receipt, property or service judgments experience recognition and recording at fair market value. The payer and the recipient must also account for the tax implications of the property or services, such as depreciation, amortization, or income in kind.
- Structured settlement agreements recognize and disclose paid or received judgments. A structured settlement is an arrangement where the payer agrees to pay the recipient a series of periodic payments over a specified period, instead of a lump sum. The recipient can exclude the entire amount of the structured settlement from their income, as long as the structured settlement meets certain requirements, such as being based on a physical injury or physical sickness, being fixed and determinable, and not being subject to any acceleration, deferment, or modification.
- Resolving contingent payments recognizes and reports judgments. A contingent payment is a payment that is dependent on the occurrence or nonoccurrence of a future event or condition, such as the outcome of an appeal, the performance of a contract, or the verification of a fact. As the payer or the recipient, you must estimate the amount and the probability of the contingent payment, and adjust your tax liability accordingly.
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Recap
The main factors that determine the tax consequences of judgments are the origin of the claim, the identity of the payer and the recipient, and the terms of the settlement or judgment agreement.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. . For comprehensive tax, legal or financial advice, always contact a qualified professional in your area. S’witty Kiwi assumes no liability for actions taken in reliance upon the information contained herein.
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