Accidents happen, and while no one desired that outcome, people still need to be responsible for the unfortunate incident. Among the tools at the legal system's disposal for disciplining negligent parties are punitive damages.
Punitive damages are unique in terms of their intended purpose. You must know how to manage them, or else you could be the one who runs into trouble with the law.
In this article, we'll go into the topic of punitive damages and how to handle them from a tax standpoint. Dealing with punitive damages can be complicated, so allow the information featured in this article to help you out.
What Are Punitive Damages?
Once it’s proven in court that you were involved in a car accident or some other incident you did not cause, They will likely award you some form of compensation. In court cases, they call that compensation damages.
You can break damages down into two major categories.
First off, you have the compensatory damages. The name should tip you off to what compensatory damages are. They are supposed to offer financial compensation for the losses you incurred due to the accident.
The courts classify compensatory damages as either actual or general damages.
Actual compensatory damages refer to your quantifiable losses such as your medical expenses, damage done to your property, or paychecks you missed out on due to your injuries. Actual damages are supposed to provide direct and equivalent compensation for those losses.
General damages are the opposite, meaning they compensate you for losses that you cannot quantify. Examples of general damages include emotional distress, a decrease in quality of life, and potential job opportunity losses.
The different kinds of compensatory damages are with your losses in mind. They are supposed to cover your needs.
Punitive damages are different because they are more focused on the guilty party. Courts set punitive damages to punish the guilty party. They are additional penalties handed down to defendants with possible incarceration and other forms of punishment.
The courts also set punitive damages because they want to teach the guilty party a lesson. They want to discourage that party in question from engaging in that behavior again. The hope is that the financial blow will get that lesson to stick a bit better.
When Are Punitive Damages Awarded?
An important thing to note about punitive damages is that they are far from common. Judges will not order them to be included in compensation simply because another party was negligent.
For courts to include punitive damages in the financial award handed down to a plaintiff, they must prove that the defendant acted recklessly with malice or deceit. They must also show that the guilty party willingly engaged in the activity that led to the incident in the first place.
Judges may also decide to include punitive damages in their ruling if they believe doing so will be an effective deterrent to others in the future.
As you can probably guess, there's a high threshold for setting punitive damages and often isn't reached. Even so, you must know how to manage them if they include them in your case.
Do You Have to Pay Taxes on Punitive Damages You Receive?
Now that we know more about punitive damages, it’s time to figure out if they are taxable. The short answer is yes, punitive damages are indeed taxable, according to the IRS. That’s another point of difference between compensatory and punitive damages because some of the former are not taxable.
You may be wondering why punitive damages are considered taxable. The IRS has an explanation for that as well.
According to the agency, punitive damages are taxable because they consider them as taxable income. Their main goal is not to provide compensation, so they see them as a windfall for the plaintiff. They aren’t similar to lottery winnings per se, but they are on the same wavelength.
Are There Cases Where Punitive Damages Are Not Taxable?
Most of the time, if you received punitive damages, you would pay taxes on them. That's the law, and you must abide unless you want to experience some legal troubles yourself.
However, there are exceptions to that law, and they mainly come into play in wrongful death cases. Financial compensation in wrongful death cases is sometimes harder to parse through because there are so many elements included.
Financial awards for wrongful death cases account for actual and general compensatory damages, and they include punitive damages because the offending party has likely met the conditions for them.
The compensatory damages may or may not be taxable. That’s contingent on a few factors that we can discuss in a separate article.
But what about the punitive damages? Are they still taxable in this scenario?
To find out the answers to those questions, you will need to consult with your state’s laws.
In wrongful death cases, the courts usually refer to the state statutes to come up with a ruling. If the state laws indicate that the financial awards provided in wrongful death cases are all punitive damages, they will be exempt from taxation.
Seeking out a lawyer familiar with the laws in your area should help you understand the status of the compensation you received. Don’t hesitate to seek out their help if you need more guidance regarding your taxes.
What Happens if You Reach a Settlement?
Not all cases reach a verdict in court. These matters often double as negotiations, and both sides may decide that settling now is more palatable than potentially spending months or even years tied up in a long legal battle.
Settling offers a way for both sides to compromise and put the issue behind them.
So, how will opting for a settlement affect your tax situation? That is an interesting question.
Determining whether a certain amount is taxable is easy enough if the court decides because the rulings usually indicate which damages are considered compensatory or punitive. The opposing sides don’t need to do that if they were negotiating a settlement.
The two sides have more control over how the documents will be written out. That is a situation where the IRS may get involved to determine if a portion of the damages awarded should indeed be taxable.
What Is Reallocation?
The next topic we need to discuss is reallocation. Using an example will make it easier to comprehend.
Let's say that the camps of the plaintiff and the defendant decide that they don't want to go to trial. They want to get the matter over with as soon as possible, so they negotiate a settlement.
During those negotiations, the plaintiff may want to classify most of the settlement amount as compensation for their injuries and losses. The plaintiff may do that in the hopes of avoiding a bigger tax bill.
Is that tactic going to work? There’s a good chance that it won’t.
The IRS has a trump card that it can use in that situation. It’s known as reallocation.
The agency may take a closer look at the court documents and see if the amount the plaintiff claims to be solely for compensatory damages is valid. You could count on the IRS going through those documents with a fine-tooth comb to see if everything listed is correct.
Now, if the agency finds that the plaintiff’s claims are wrong, they will let the court know about that. Though the plaintiff indicated that all the money they received is compensatory, the IRS may argue that they should earmark at least a percentage of it for punitive purposes.
The IRS can then reallocate the funds the plaintiff received and argue in court that their arrangement is the right one. Because of all that, the plaintiff may end up paying more taxes.
The bottom line here is that settling will not allow you to avoid taxes. There are cases where negotiating a settlement makes sense, but don’t use taxes as your primary incentive for going down that route.
Handling the Interview
If the IRS believes there's something suspicious about the tax filings related to your settlement, they may request to interview you. The goal of the interview is to determine why your filing looks that way. They’re also trying to figure out if the settlement amount you reported is taxable.
Expect the IRS agent to ask a variety of questions regarding the settlement.
They may ask why you opted to settle out of court in the first place. They will also likely ask why the other party agreed to the settlement.
Getting more to the heart of the matter, the IRS agent conducting the interview may also ask if they discussed punitive damages during the settlement negotiations. They may wonder if you were aiming for punitive damages before settling.
It’s also possible that the IRS agent will ask about the conversations with your lawyer. They may wonder if your lawyer mentioned pursuing punitive damages at some point.
What should you do if an IRS agent drops by unannounced and asks you those questions? The first thing you should do is contact your lawyer.
Some IRS agents may not tip you off to the fact that they are investigating your filings to obtain important information from you. By catching you off guard and maintaining a friendly tone, they hope you would talk without consulting with your lawyer first.
In that situation, it's important to remember that you don't need to say anything. Let the agent know that you have nothing to say without your lawyer present, and they should leave not long after that.
Handling Document Requests
If their attempt to obtain information from you via an interview fails, the IRS may turn to document requests to get what they need. The agency may file a formal request to obtain documents from you, including copies of your court petitions, the settlement agreement, and certain checks.
The IRS may also ask you to detail your legal fees as well as your communications with your lawyer.
A request such as that can be intimidating, and you may be spooked by it greatly. Don’t panic, though.
Once again, the right move in that situation is to get in touch with your lawyer and ask them what you should do next. Dealing with the IRS on your own can be scary, but you don’t need to do that.
Partner with a lawyer if you haven’t done so already and make this ordeal easier to manage.
What Happens if You Make a Mistake while Reporting the Punitive Damages You Received?
Chances are you don’t have a ton of experience reporting income from awarded damages. Because of that, mistakes can happen from time to time.
What happens if you made a mistake while reporting the financial compensation you received? How much trouble could you potentially be in?
Likely, the penalties you’ll face will come in the form of additional payments. The IRS may hit you with penalties regarding failure to file or failure to pay. At that point, you can probably still pay the penalties and take care of this stressful issue.
Now, if the IRS claims that you intentionally filed fraudulent documents, you could be staring at stiffer penalties. It's best to avoid that by being honest with your filings right from the get-go.
The importance of cooperating with a lawyer cannot be stressed enough if you’re dealing with the IRS. Your lawyer can solve a lot of your problems and get the matter settled as soon as possible.
Receiving punitive damages can lead to headaches if you aren’t careful about reporting them. Make sure you handle the process correctly by working an experienced lawyer. Contact us at the Saeedian Law Group and let us help with any issues related to the punitive damages you received.