Taxation of Lost Profit Damages
In contrast to personal injury and wrongful death
awards, business injury awards are generally considered taxable income to
the plaintiff. However, the nature and characterization of any damages
recovered by a business will generally determine whether they must be
recognized as ordinary income or capital gain.
Lost profit damages in the hands of a plaintiff-business owner are typically
considered ordinary income. As a result, a professional valuation expert and
careful planning are necessary, as a significant percentage of lost profit
damages may have to be allocated to offset the associated tax liability.
Business Injury Awards
Business injury awards typically encompass some combination of lost profits
or damages to capital assets and/or goodwill. However, it is not necessarily
obvious whether damages asserted by a plaintiff involve an asset that is
used in a trade or business--which would result in an ordinary gain or
loss--or a capital asset--which results in the realization of a capital
gain or loss. Therefore, business injury awards or damages will generally be
taxed in the same manner that profits or asset transactions would have been
taxed in the plaintiff’s business. Normally, the burden of proof is on the
plaintiff to show the nature of the asset at issue. Two tests are commonly
employed to determine whether damages recovered relate to lost profits or
business assets.
Origin-of-the-Claim Test and Primary Purpose Test
A guiding principle in the characterization and taxation of business damages
is that those damages are generally taxed in the same manner as the
corresponding payments would have been taxed if no litigation had occurred.
Accordingly, looking to their origin to determine tax treatment, damages
representing lost profits will be taxed in the same fashion as actual
profits would have been taxed to the taxpayer in his or her resident state.
In contrast, the primary purpose test generally looks at the reason the
defendant paid an amount to the plaintiff.
Capital Assets and Goodwill
Damages received on account of a loss to or impairment of a capital asset
are generally considered to be capital in nature. Furthermore, any recovery
attributable to capital assets is generally treated in the same manner as a
sale or exchange of that asset would have been treated. In this context, a
plaintiff would not realize a capital gain if the amount of recovery does
not exceed the plaintiff’s basis in the capital asset.
The concept of goodwill historically has created difficulties for courts and
practitioners in regard to its categorization within business damages. On
the one hand, as an intangible asset, goodwill is generally considered to be
a capital asset. Accordingly, losses of goodwill will typically be
considered nontaxable if they do not exceed its basis. However, valuation
complexities can arise in a situation where a business owner did not
purchase the business (and would have a corresponding basis in goodwill),
but, rather, has nurtured the goodwill him- or herself. Under such
circumstances, some courts have categorized the loss of goodwill as a loss
of profits, as opposed to a capital loss.
How a Valuation Expert Can Help
The impact of income taxes on the recovery of lost profits can be
significant. A valuation expert can assist with the nuances associated with
asserting lost business damages. An award or settlement for lost profits, as
determined on a pretax basis, may seem to make the plaintiff whole. However,
other factors need to be carefully assessed when determining whether a
settlement or award is accurately calculated.
For instance, a qualified tax expert can examine whether an award or
settlement representing lost profits might change the timing of certain
income tax deductions. Or the expert can assess whether the award or
settlement results in the loss of a tax benefit--such as a depreciation
allowance or an income tax credit. Also, a tax expert can help quantify the
loss as of the time the cause of action arose and compare it to a
calculation based on the impact of any law change(s) that may occur during
the course of litigation or settlement. This would allow the proper
measurement of the income tax effects.
Conclusion
Attorneys confronted with a situation involving damages to a business may
venture into the arena of lost profit damages. It’s important to understand
the income tax ramifications of asserting such a claim, as such damages will
commonly be categorized as ordinary income. Somerset can provide the
assistance your clients need in determining whether all relevant factors
have been taken into account when quantifying a loss associated with lost
profit damages. Please
contact us.
This newsletter is provided by
Somerset for our clients and other interested persons upon request.
Since technical information is presented in generalized fashion, no
final conclusion on these topics should be made without further review.
For additional information on the issues discussed, please contact
Steve Riddle,
Tom
Thieme,
Rex Collins or
Doug
Ayres
of our
Litigation & Valuation Team.
This document is not intended or written to be used, and cannot be used,
for the purpose of avoiding tax penalties that may be imposed on the
taxpayer.
Somerset CPAs,
P.C.
3925 River Crossing Parkway, Third Floor
Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
www.somersetcpas.com
info@somersetcpas.com
