Receiving Punitives? The Tax Laws Are Even More Punitive!

Are Punitive Damages Taxable?

Punitive damages are always fully taxable. This unwelcome and often unknown fact is true when punitive damages are awarded in conjunction with a tax-free compensatory award (e.g., physical injuries or sickness) or a taxable claim (e.g., non-physical injuries, defamation, or another tort).

How Much Tax Is Paid on a Lawsuit Settlement

The taxes you will pay are likely much higher than you think. Under the current tax code, you must pay taxes on the portion of the punitive award you do not even receive – like the attorney’s fees and costs.

Double Taxation of Punitive Proceeds

Unfortunately, under our tax laws, a person as a plaintiff receiving punitive damages is fully taxed on the punitive portion and is thus treated more punitively than the defendant paying them. This harsh tax reality is because of the odd but real “plaintiff double tax.” ¹

The plaintiff’s double tax arises because the plaintiff is taxed on the entire taxable recovery – including the punitive damages – but cannot deduct the attorney fees and costs associated with the recovery. That is because such fees and costs are treated as “miscellaneous itemized deductions” (MIDs), which are not fully deductible.

Double Tax Example

Here is a realistic example: Joan, living in California, receives $2,000,000 in damages for a physical injury and an additional $10,000,000 in punitive damages. The $2,000,000 isn’t taxed, but the $10,000,000 punitive portion of the settlement is.

Out of the above, Joan owes her attorneys a 40% contingency fee on the punitive portion ($4,000,000). However, she cannot deduct the attorney’s fees for federal or state income tax purposes. Also, her combined Federal and State income tax rate is around 50% since she’s in the top tax bracket. As a result, her “net-net” (after-tax and attorney fees) proceeds on the punitive portion is around $1,000,000 - just 10 cents on the dollar of the total punitive proceeds, and could be even less!

WOW, poor Joan – Regretfully, there are other unpleasant realities Joan shall be surprised to learn:

• Not being able to deduct the attorney fees due to the plaintiff’s double tax costs Joan $2,000,000 in increased taxes, more than twice what Joan received! (50% tax of the $4,000,000 in attorney’s fees is an extra $2,000,000 in taxes).
• For any incurred case costs, Joan must reimburse her lawyer; she shall further reduce her “net-net” after-tax proceeds, meaning Joan shall likely receive far less than 10 cents on the dollar.
• Also, if Joan lives in a municipality with a city tax, her net-net proceeds would be even lower.

Talk about punitive! (Other epithets may come to mind.)

In certain limited case types, such as employment and civil rights discrimination, an “above the line” deduction is indeed allowable for attorney’s fees and costs, avoiding the plaintiff’s double tax. However, this deduction rarely applies since punitive damages are infrequently awarded in those cases.

Caution – PRO TIP: Various dubious suggestions haunt the internet and purport to circumvent the plaintiff’s paying taxes on the attorney portion of the taxable recovery. These suspect “tax tricks” are designed to misclassify a portion of the proceeds, including issuing separate Form 1099s for the plaintiff and the attorney or alleging a quasi-partnership arrangement between the plaintiff and the attorney. Thus, take caution; the Supreme Court precluded these approaches in the Commissioner v. Banks Supreme Court decision. Employing such tenuous schemes may open the door to significant tax underpayment penalties and possibly even more severe allegations and actions by the IRS. Also, the above-the-line deduction is plainly shown on the tax return and is a glaring audit signal to the IRS; the larger the deduction, the more likely the audit risk.

There is a Solution

Plaintiffs who may receive punitive damages may wish to consider a Plaintiff Recovery Trust (PRT) before the claim becomes final or fully settled. A PRT is a specially designed trust that could increase the after-tax recovery by 50% to 150%, and the PRT does not rely on the “above the line deduction.” However, timely action is necessary, and the PRT must be in place before the matter is finalized, including appeals, so the earlier in the case cycle, the better, and a failure to act promptly could result in unnecessary taxation.

How to Reduce Taxation on Your Settlement Proceeds

To learn more about PRTs, visit the PRT web page or call (855) 222-7513 to speak with a PRT Expert to see if your case qualifies.