Taxation of Business Injury Awards

Although personal injury awards or damages that are paid for a plaintiff's personal physical injuries and physical sickness are generally not taxable, business injury awards generally are taxable. Business injury awards include damages for lost profits, capital assets, or goodwill.

Two Tests

When a plaintiff recovers damages in a tort action, the taxation of those damages will depend upon how the plaintiff's claim was characterized. The damages are generally taxed in the same manner that the underlying resource or asset would have been taxed if there had been no litigation. For example, if the plaintiff's claim was based on lost profits, the damages will be taxed in the same manner as the plaintiff's profits are taxed. This is called the origin of the claim test. A court may also look at the reason that a defendant paid damages to the plaintiff or the defendant's primary purpose in paying damages to the plaintiff. This is called the primary purpose test.

Under either the origin of the claim test or the primary purpose test, a court will determine whether the damages that are paid to a plaintiff involve an action for lost profits or for damage to business assets. If the damages compensate the plaintiff for lost profits or damage to business assets, they will be taxed in the same manner that the profits or assets would have been taxed in the plaintiff's business.

If a plaintiff receives damages for lost profits, the damages will normally be taxed as ordinary income. Examples of damages for lost profits include damages to crops from defective pesticides, misappropriation of corporate profits by a director or an officer, or damages for antitrust violations.

If a plaintiff receives damages for an injury to a capital asset, the damages will normally be taxed as a capital gain, which is generally taxed at a lower rate than ordinary income. Capital assets include such property as houses, automobiles, equipment, stocks, and bonds. They do not include inventory, trade accounts and receivables, or depreciable property that is used in a trade or business. If damages are paid to a plaintiff for an injury to a capital asset, they are normally treated in the same manner as the sale or exchange of that asset would be treated. In other words, the plaintiff does not recognize any income unless the amount of the recovery exceeds the plaintiff's basis in the capital asset. For example, if a sale of the asset would result in a capital gain, the damages that are paid for the injury to the asset would be a capital gain. If the sale of the asset would result in a capital loss, the damages that are paid for the injury to the asset would not be taxable.

Burden of Proof

It is often difficult to determine whether damages that are paid to a plaintiff involve a capital asset, which may result in a capital gain or loss, or an asset that is used in a trade or business, which would result in an ordinary gain or loss. A taxpayer has the burden of proving that an asset was a capital asset in order to receive capital gain or loss treatment for the damages.

The goodwill of a business is considered to be a capital asset of the business. Goodwill is an intangible asset. It is defined as the value of a business that is over and above the assets of the business. If a plaintiff is paid damages for his or her business's goodwill, the damages are treated in the same manner as the sale or exchange of a capital asset. Damages for the loss of goodwill are nontaxable if they do not exceed the plaintiff's basis for the goodwill. Damages for the loss of goodwill are treated as a capital gain if they exceed the plaintiff's basis for the goodwill.

Because goodwill is an intangible asset, it may be difficult to evaluate the amount of a plaintiff's goodwill and the plaintiff's basis in the goodwill. This most often occurs when the plaintiff has generated the goodwill in his or her business and did not purchase a business with an established amount of goodwill. In this type of situation, courts have been known to measure goodwill in terms of lost profits, even though goodwill is a capital asset.

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