People who sue in court for justice commonly receive awards for damages and then complain about unjust income tax consequences. The tax treatment for damage awards depends upon the type of damage. When these situations are encountered during work by Enrolled Agents, questions are asked about what the payment for damages replaces. The key element explored during these jobs for Enrolled Agents is the purpose of the lawsuit.
Damages awards have the same tax character as the remittance would have had if paid in the absence of a court case. For instance, damages received by an employee to recover wages owed are treated just like ordinary compensation. Alternatively, a lawsuit initiated by a creditor to recover a loan is a return of principal – along with perhaps some interest. Differential income tax results imposed on these payments are clearly identified in an Enrolled Agent course. Situations become a little tricky for EAs when courts award multiple categories of damages.
A particularly complex type of damage award is restitution for injury or sickness. This category has a special designation under the tax rules. Although damage awards in personal injury cases are often determined based upon lost wages, the recipient may exclude reporting such damages as income.
Essentially, recovery of diminished value in a lawsuit award is not considered taxable income. These matters comprise very challenging Enrolled Agent jobs. However, they are even more difficult for taxpayers to decide without professional tax advice. A taxpayer named Cung failed to report a damage award under the principle that it represented lost value. He recently failed to convince the Tax Court of his position.
The court reasoned that the taxpayer did not incur any genuine loss of value, despite his argument that he had a constructive loss. Cung saw an automobile advertisement stating a price that he eventually learned from the seller was erroneous. The correct price was $20,000 higher. He sued the advertiser and settled for $17,000.
As often occurs with settlement agreements, the parties did not specify whether the damages paid are compensatory or punitive. When unusual legal settlements are presented as EA problems, the solutions turn to the facts contested in the lawsuit. That’s exactly what the Tax Court did when it noted that Cung’s original civil suit against the vehicle seller sought damages for violations of California’s unfair competition law, false advertising law, and consumer remedies act as well as breach of contract.
Cung received an award for his lost opportunity to purchase the automobile for $20,000 less. The payment of $17,000 enriched Cung rather than replaced lost value. The circumstances surrounding this case reflect an important standard addressed during Enrolled Agent exam prep. That’s the concept of economic gain or loss, which is the ultimate test for deducing whether amounts received are income or whether foregone amounts are tax-deductible losses.
When recipients of damage awards are economically wealthier, the amount received is taxable income. Similarly, tax deductions are determined when taxpayers are economically poorer. For this reason, individuals cannot receive tax deductions for bad debts that are only unpaid bills rather than non-repayment of funds previously advanced.
Interestingly, Cung used a paid tax preparer. However, instead of seeking guidance from the tax pro, Cung conducted his own analysis. Then, he simply failed to convey details about the $17,000 to his tax preparer. This resulted in the combination of two bad ideas – not getting sound tax advice and withholding information about sources of income.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.