When a party involved in a lawsuit makes a payment pursuant to a judgment or binding settlement agreement, the payment may be included in the recipient's income and may be deductible from the payor's income. A separate issue that also arises in litigation is whether either party may deduct the legal expenses incurred in the suit. The nature of the underlying claim is critical in determining the proper tax treatment of these payments and expenses. This report examines the tax consequences of these payments and expenses. It ends with a summary of the legislation proposed in the 109 th Congress that would affect these consequences. For tax purposes, it does not matter whether the payment is made pursuant to a judgment or a binding settlement agreement. Furthermore, a payment made in a lump sum has the same consequences as a payment made in periodic installments, although the timing of the inclusion and/or deduction will differ. In this report, the terms "award" and "damages" are used interchangeably and intended to include all such payments. Portions of a payment may face different treatment depending on what each represents (e.g., replacement for lost wages, reimbursement of medical expenses, or punitive damages). The different parts may be designated by the court in the judgment or by the parties in the settlement agreement. The parties must generally follow these allocations for tax purposes. If the judgment or agreement is silent, then the taxpayer must make the appropriate allocations. In any case, the Internal Revenue Service (IRS) or a judicial authority may reallocate the payment to properly reflect the actual substance of the award. In order to determine the appropriate allocation, the IRS and reviewing authorities will look at such things as the complaint, other pleadings, evidence presented at trial, and a settlement agreement. For awards received pursuant to a judgment or settlement for claims involving personal physical injury or sickness, the recipient's tax consequences are determined under section 104 of the Internal Revenue Code (IRC). For all other claims (i.e., non-personal injury and personal non-physical injury claims), general tax principles include the award in the recipient's income unless an exclusion exists for the item of income that the payment is meant to replace. Under IRC § 104(a)(2), "the amount of any damages (other than punitive damages) received on account of personal physical injuries or physical sickness" is excluded from the recipient's gross income. This includes all non-punitive damages, including economic ones (e.g., lost wages), that are received because of the personal physical injury or sickness. However, any amount that is attributable to medical expenses that have already been deducted may not be excluded. IRC § 104(a)(2) does not define physical injury or sickness beyond excepting emotional distress. Congress did not intend the physical symptoms of emotional distress to be considered physical injury or sickness. The IRS appears to take the position that physical injuries stem from "direct unwanted or uninvited physical contacts resulting in observable bodily harms such as bruises, cuts, swelling, and bleeding" or causing pain. Prior to 1996, the injury or sickness did not have to be physical in order for the award to be excluded under IRC § 104(a)(2). When deciding if the exclusion applied, courts looked solely at whether (1) the injury or sickness was personal as opposed to professional and (2) the claim was tort or tort-like as opposed to contractual. This led to inconsistent results, particularly about whether damages received for various claims of discrimination qualified for exclusion. In the Small Business Job Protection Act of 1996 (SBJPA), P.L. 104-188 , Congress amended the statute to add the physical requirement. It is now clear that damages for discrimination claims are included in income since such claims do not involve physical injury or sickness. Under IRC § 104(a)(2), awards for emotional distress are included in the recipient's income unless the emotional distress had its origin in physical injury or sickness. Emotional distress is intended to include the "symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such distress." If medical care for the emotional distress was sought, then damages equal to those medical costs may qualify for exclusion. Under IRC § 104(a)(2), as amended by SBJPA, punitive damages that are received on account of personal physical injury or sickness are included in the recipient's gross income. A limited exception exists under IRC § 104(c) for punitive damages awarded in a wrongful death action if state law, as existing on September 13, 1995, only allows the recovery of punitive damages. Courts have repeatedly held that if an award includes prejudgment interest, the interest may not be excluded from gross income under IRC § 104(a)(2). An award may include an explicit amount that represents the recipient's attorneys' fees and other legal costs. This may occur because the court awards the expenses under a fee-shifting statute, the settlement agreement includes the expenses, or there is a contingency fee agreement that grants a specified portion of any award to the attorney. If an award is excluded from the recipient's income under IRC § 104(a)(2), then any amount that represents attorneys' fees and other legal costs is also excluded from the recipient's income. The amount will be included as compensation in the attorney's income. Deductibility . A plaintiff with a physical personal injury or sickness claim may not deduct the legal expenses incurred in the suit. This is because expenses incurred in the production of tax-exempt income are not deductible. No statutory exclusion exists for payments received pursuant to a judgment or settlement in non-personal injury and non-physical personal injury cases. The treatment of an award is determined by general tax principles that include the award in the recipient's income unless it is properly designated as a return of capital or there is a statutory exclusion for the item of income that the payment is intended to replace. This is determined by the nature of the underlying claim. For example, an employment suit is a breach of contract claim and any award for back pay is meant to substitute for the payment of wages. Since there is not an exclusion for wages from gross income, the award is included in gross income. If an award is included in the recipient's gross income, it must be characterized as ordinary income or capital gain. This is important because it determines such things as the appropriate tax rate. The characterization is made by looking at the nature of the underlying claim. For example, if a payment is meant to replace lost profits, then the award is treated as ordinary income. However, if the payment is to redress an injury to a capital asset, then the amount should be treated as capital gain. Punitive damages that are awarded for a claim of non-personal injury or non-physical personal injury are included in the recipient's income. In suits claiming patent infringement, breach of contract, breach of fiduciary duty, or the violation of antitrust laws, the award recipient may be allowed a deduction under IRC § 186 if the compensatory portion of the award is included in income. The amount that may be deducted is the lesser of the compensatory payment less the costs of securing it or the amount of unrecovered net operating loss attributable to the injury. As mentioned above, an award may include an explicit amount that represents the recipient's attorneys' fees and other legal costs. Prior to a Supreme Court decision in 2005 (discussed below), it was unclear whether this amount was included in the recipient's income when it was received as part of an award in a non-personal injury or non-physical personal injury case with a contingency fee agreement. Courts generally required it be included in the recipient's income. This approach was consistent with three fundamental tax principles: (1) payments are included in income unless specifically excluded by statute, (2) a taxpayer may not avoid taxation by assigning income to another party, and (3) a taxpayer receives a taxable benefit when another party pays his or her debt. However, some courts allowed the amount to be excluded from the recipient's income. This position had several bases: (1) the attorney's right to the income under state lien law, (2) the recognition that contingency fee agreements are not made with a tax-avoidance purpose and that inclusion of the fees in the client's income results in the amount being subject to double taxation, and (3) equitable reasons due to the fact that the recipient may not be able to fully deduct the legal expenses, as explained below. In 2005, the Supreme Court resolved the conflict by holding that the recipient is required to include the amount representing attorneys' fees in income. The Court appeared to answer the question with relative ease based on settled law. It began by stating that in situations involving anticipatory assignment of income, like contingency fee agreements, the test for determining if the assignor received the income for tax purpose is if he or she retains control over the income-generating asset. The Court then reasoned that because the cause of action resulting from the injury is the income-generating asset and the injured party retains control over it throughout the litigation, the injured party receives all of the award for purposes of taxation. The Court rejected the argument that the attorney had an ownership interest in the asset because he or she also contributed an income-generating asset (i.e., effort and expertise) or was granted it under state lien law. A plaintiff with a claim of non-personal injury or non-physical personal injury may be able to deduct the legal expenses incurred in the suit. Business plaintiffs may generally deduct the entire amount of attorneys' fees and other litigation costs as business expenses under IRC § 162. However, if the award was treated as capital gain, then the legal expenses should be capitalized rather than currently deducted. The deductibility of non-business plaintiffs' attorneys' fees will depend on the type of claim. Individuals with certain claims may deduct attorney fees and court costs as an above-the-line deduction.