Are Awarded Monies Tax Free?

Are-Awarded-Monies-Tax-Free

The question occasionally comes up: Are awarded monies tax free? The answer depends on the circumstances. Keep reading to learn more about tax code tips for awards and how they apply to specific cases.

To Tax or Not to Tax

In general, you must pay federal tax on all income you receive, but there are some exceptions when you can exclude it. For example, compensatory awards and judgments for “personal physical injuries or physical sickness” are free from federal income tax under the tax code. This includes amounts received in a lawsuit or a settlement and in a lump sum or in installments.

But as taxpayers in two U.S. Tax Court cases learned, not all awards are tax-free. For example, punitive damages and awards for unlawful discrimination or harassment are taxable. And the tax code states that “emotional distress shall not be treated as a physical injury or physical sickness.”

Here are the facts of the two cases.

Case 1: Payment for Personal Injuries, Not Physical Injuries

A taxpayer received a settlement of more than $327,000 from his former employer in connection with a lawsuit. He and his spouse didn’t report any part of the settlement on their joint tax return for the year in question. The IRS determined the couple owed taxes and penalties of more than $119,000 as a result of not including the settlement payment in their gross income.

Although the settlement agreement provided the payment was “for alleged personal injuries,” the Tax Court stated there was no evidence that it was paid on account of physical injuries or sickness. The court noted that the taxpayer’s complaint against the employer “alleged only violations of (state) labor and antidiscrimination laws, wrongful termination, breach of contract, and intentional infliction of emotional distress.”

The taxpayer argued that he had a physical illness that caused his employer to terminate him. But he didn’t provide a “direct causal link” between the illness and the settlement payment. Therefore, the court ruled, the amount couldn’t be excluded from his gross income.

Case 2: Legal Malpractice Payment Doesn’t Qualify for Exclusion

This case began when the taxpayer was injured while receiving medical treatment at a hospital. She sued for negligence but lost her case. She then sued her attorneys for legal malpractice.

She received $125,000 in a settlement of her lawsuit against the attorneys. The amount was not reported on her tax return for the year in question. The IRS audited the taxpayer’s return and determined that the $125,000 payment should have been included in gross income. The tax agency issued her a bill for more than $32,000 in taxes and penalties.

The taxpayer argued that the payment was received “on account of personal physical injuries or physical sickness” because if it wasn’t for her former attorneys’ allegedly negligent representation, she “would have received damages from the hospital.” The IRS argued the amount was taxable because it was for legal malpractice and not for physical injuries. The U.S. Tax Court and the 9th Circuit Court of Appeals agreed with the IRS.

Strict Requirements

As you can see, the requirements for tax-free income from a settlement are strict. So, are awarded monies tax free? The answer really depends on your situation, but we can help. The tax professionals at Ramsay & Associates are here to answer your questions. If you receive a court award or out-of-court settlement, consult with us about the tax implications.

About the author

Brady is the owner of Ramsay & Associates. He specializes in financial statement preparation and personal, fiduciary and corporate tax and accounting.

His professional experience includes seven years' experience for local and national CPA firms before joining Ramsay & Associates in 2006.

He has a Bachelor of Accounting degree from the University of Minnesota Duluth. He is a Certified Public Accountant, a member of the Minnesota Society of CPA's, an Eagle Scout, as well as an active volunteer in the community.

What to Know When Donating Appreciated Assets

What-to-Know-When-Donating-Appreciated-Assets

Are you charitably inclined? If so, you probably know that donations of long-term appreciated assets, such as stocks, have an advantage over cash donations. But in some cases, selling appreciated assets and donating the proceeds may be a better strategy. That’s because adjusted gross income (AGI) limitations on charitable deductions are higher for cash donations. Plus, if the assets don’t qualify for long-term capital gain treatment, the deduction rules are different. Here’s what to know when donating appreciated assets.

Tax Treatments by Type of Gift

All things being equal, donating long-term appreciated assets directly to charity is preferable. Not only do you enjoy a charitable deduction equal to the assets’ fair market value on the date of the gift (assuming you itemize deductions on your return), you also avoid capital gains tax on their appreciation in value. If you were to sell the assets and donate the proceeds to charity, the resulting capital gains tax could reduce the tax benefits of your gift.

But all things aren’t equal. Donations of appreciated assets to public charities are generally limited to 30 percent of AGI, while cash donations are deductible up to 60 percent of AGI. In either case, excess deductions may be carried forward for up to five years.

Work the Math

If you’re contemplating a donation of appreciated assets that’s greater than 30 percent of your AGI, crunch the numbers first. Then determine whether selling the assets, paying the capital gains tax, and donating cash up to 60 percent of AGI will produce greater tax benefits in the year of the gift and over the following five tax years. The answer will depend on several factors, including the size of your gift, your AGI in the year of the gift, your projected AGI in the following five years, and your ability to itemize deductions in each of those years.

Before You Donate

Before making charitable donations, discuss your options with us. The tax professionals at Ramsay & Associates can help you understand what to know when donating appreciated assets so that you can make charitable gifts at the lowest tax cost.

About the author

Brady is the owner of Ramsay & Associates. He specializes in financial statement preparation and personal, fiduciary and corporate tax and accounting.

His professional experience includes seven years' experience for local and national CPA firms before joining Ramsay & Associates in 2006.

He has a Bachelor of Accounting degree from the University of Minnesota Duluth. He is a Certified Public Accountant, a member of the Minnesota Society of CPA's, an Eagle Scout, as well as an active volunteer in the community.