Taxation of Liquidated Damages

The Internal Revenue Service (IRS) treats liquidated damages as taxable income. Although damages for physical injuries and illnesses can be excluded from taxation, other lawsuit damage awards, including liquidated damages, are taxable, according to the Internal Revenue Code. The IRS requires recipients of liquidated damage awards to include them as income on tax forms.

Liquidated damages are predetermined monetary damage awards to compensate parties for unfulfilled contractual duties or late payments. Many contracts contain liquidated damage provisions, and contract attorneys use them when damages are otherwise difficult to ascertain.

For instance, if a furniture wholesaler receives a late shipment of dining tables, the distributor may have to pay him a specific sum of money as liquidated damages for the late delivery to compensate him for lost sales and profits.

The Internal Revenue Code Section 104 explains that taxpayers are allowed to exclude their lawsuit settlement awards for pain and suffering.

The Internal Revenue Code Section 104 explains that taxpayers are allowed to exclude their lawsuit settlement awards for pain and suffering. Most often, litigants receive pain and suffering awards when they file personal injury or tort claims. Compensatory damage awards or physical injuries or illnesses are not taxable, even when paid over time, instead of in lump-sum payments.

Taxpayers may also exclude their disability benefits or workers' compensation awards in limited circumstances. To exclude a workers' compensation award as income, the IRS requires taxpayers to receive them pursuant to state or federal statutes. In other words, if a taxpayer receives a workers' compensation award under her state workers' compensation act, she does not have to report it on her tax returns.

Furthermore, the IRS allows taxpayers to exclude their pain and suffering or emotional distress awards if attributable to physical injuries as noted in IRC Section 104.2(a).

The IRS requires taxpayers to report their punitive damage awards. Punitive damage awards are monetary awards compensating victims for their pain and suffering, in addition to their actual damages. Section 104(c) of the Internal Revenue Code provides a limited exception to otherwise taxable lawsuit awards to victims who receive punitive damages pursuant to state law, which reimburses them for pain and suffering.

Under the narrow exclusionary rule, victims of wrongful death suits can exclude their pain and suffering awards if their state's laws do not allow juries or judges to award other types of damage awards. You can find this information mapped out in Section 104(c) of the Internal Revenue Code.

Taxpayers who receive back-pay awards or settlements for unpaid wages must include them as income. Additionally, taxpayers who receive emotional distress awards from winning their employment discrimination suits or injury to reputation claims must report them as income. Similarly, prevailing parties of lawsuits for damage to professional image claims must pay taxes on their winnings.

If your situation is unique and does not fall under any of these circumstances, your best option is to seek the counsel of a professional accountant. They will be able to tell you how to file the income and how to provide documentation to prove the situation to the IRS.