Tax Treatment on Class Settlement for Shareholders
Generally, the Internal Revenue Code provides that all income, "from whatever source derived," is taxable, except where another section of the tax code specifically exempts it. The specific tax treatment of lawsuit awards and settlements depends on how the awards, damages and settlements are characterized by the court system.
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IRC Section 104(a)(2)
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While the Internal Revenue Service considers many lawsuit settlements and awards to be fully or partially taxable, section 104(a)(2) of the Internal Revenue Code exempts compensatory payments made to plaintiffs who are receiving these payments as a result of sickness or injury.
Defining Sickness or Injury
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Because the text of the legislation does not closely define sickness or injury for the purposes of determining the tax treatment of awards and settlements, a number of lawsuits have been filed contesting the IRS' determination, so an evolving body of case law supplements the legislative record. Generally, the courts have held that compensation for emotional distress arising directly from the same tort that caused a physical injury also qualifies for the Section 102(a)(2) exclusion.
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Punitive Damages
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The IRS does not consider punitive damages -- as opposed to compensatory damages -- to fall under the terms of IRC 104(a)(2), and therefore damages characterized as punitive in nature are included in gross income and subject to ordinary income tax rates. Damages characterized as compensatory in nature are not taxed, as long as they fall under the auspices of IRC 104(a)(2).
Shareholder Lawsuits
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To the extent that shareholder lawsuits against companies and boards of directors for breaches of fiduciary duty are not related to personal injury or illness claims -- as is normally the case with class action lawsuits with shareholders acting as plaintiffs -- they would not fall under the IRC 104(a)(2) exception and are normally taxable as income.
However, the compensatory income received via a settlement may be offset by a tax deduction in a prior year, such as a capital loss incurred as a result of the misfeasance of the defendant or by income not received in a prior year and therefore not taxed. The punitive portion of the settlement is generally taxable as ordinary income. If a portion of the award is characterized as interest on a delayed payout, then the portion attributable to interest is taxed as ordinary income.
Wrongful Death
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The law provides for an exception from the taxation of punitive damages from lawsuits in cases involving wrongful death. However, this would not ordinarily be the subject of a shareholder class action lawsuit.
Legal Fees
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Individuals who are members of the plaintiff class may deduct legal fees as a miscellaneous itemized deduction on Schedule A of their individual income tax returns. This deduction, combined with other itemized deductions, is only allowable to the extent the combined miscellaneous deductions exceed 2 percent of the individual's annual income. However, you may not deduct attorney's fees attributable to income that's exempt from taxation. If half of your damages are compensatory and the other half punitive and therefore only 50 percent of your award or settlement is taxable, you can only deduct half of the attorney's fees, according to IRC section 265(a)(1).
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