Are Punitive Damages Taxable? Here’s What the IRS Says

HomeSettlement Tax PlanningAre Punitive Damages Taxable? Here’s What the IRS Says

Last Updated: June 2024

If you’re involved in a lawsuit that may include punitive damages, you may be wondering, 

“Are punitive damages taxable?” 

This is a great question that many plaintiffs have when navigating legal settlements. 

In this article we’ll be breaking down: 

  • The tax rules around punitive damages
  • Whether punitive damages are taxable 
  • And, most importantly, how you can reduce your tax bill in cases with punitive damages using tools like a structured settlement annuity and the Plaintiff Recovery Trust.

Please note that the information in this article is for general informational purposes only and is not intended as tax advice. 

But, before we discuss the taxability of punitive damages, we first need to define what punitive damages are.

What are punitive damages?

Punitive damages are funds awarded in legal cases that go beyond compensating a plaintiff for their actual losses. Instead of just making up for the harm done, these damages are meant to punish the defendant, especially if they acted intentionally or recklessly. 

Unlike compensatory damages, which are meant to compensate the injured party for actual losses suffered, punitive damages are designed to deter the defendant and others from similar behavior in the future.

In other words, the intent of punitive damages is to punish the defendant rather than simply make the plaintiff “whole” after an injury.

When are punitive damages awarded? 

Punitive damages are typically awarded in cases where the defendant’s conduct is deemed especially egregious or reprehensible.

The McDonald’s coffee case, often cited as an example of frivolous American lawsuits, actually underscores the importance of punitive damages in civil litigation. In 1992, Stella Liebeck, a 79-year-old woman, suffered third-degree burns after spilling McDonald’s coffee on her lap, necessitating skin grafts. The incident led to a lawsuit after McDonald’s refused to cover her medical bills, revealing that the company had prior complaints about the temperature of its coffee, which was kept hot enough to cause severe burns within seconds of contact. The jury awarded Liebeck $200,000 in compensatory damages, reduced by 20% due to her partial fault, and $2.7 million in punitive damages to penalize McDonald’s for their negligence—a sum later reduced to $480,000 by the judge.

Punitive damages, in this context, served not merely to compensate the victim but to reform and prevent harmful conduct, emphasizing that companies must prioritize consumer safety over profits. This case demonstrates how punitive damages are crucial for enforcing safety standards and protecting public interest, ensuring that businesses cannot disregard consumer well-being without significant legal repercussions.

What does the IRS say about the taxability of settlements?

The taxability of legal settlements depends on the nature and origin of the damages alleged in the lawsuit. 

Most types of legal settlements are fully taxable. One major exception to this rule is for compensatory damages received in personal physical injury cases. In cases involving personal physical injuries, the settlement is tax-free under Section 104 of the US tax code. 

How does the IRS treat punitive damages? 

According to the IRS, all punitive damages are fully taxable as ordinary income, even if the underlying compensatory damages are tax-free (like in a personal injury case).

This means that even if a plaintiff receives compensatory damages that are excluded from income under Section 104, any additional punitive damages received will be fully taxable as ordinary income. 

In short, if you receive any punitive damages, you’ll have to pay taxes on that amount (and there are no exceptions).

Why does the plaintiff owe tax on the total amount of punitive damages?

The IRS views punitive damages as a financial windfall to the plaintiff rather than as a way to make up for the damage caused by the defendant.

For example, if a plaintiff receives a $500,000 settlement for physical injuries in a car accident, that $500,000 would be tax-free compensatory damages. 

However, if the plaintiff also receives $5 million in punitive damages, the full $5 million punitive damage amount would be taxable, even if the underlying lawsuit is for a physical personal injury. 

Again, punitive damages are always taxable.

Can I deduct attorney fees attributable to punitive damages?

Before 2018, legal fees were deductible as a miscellaneous itemized deduction, albeit with some limitations. Now, miscellaneous itemized deductions are completely suspended from 2018-2025 due to the Tax Cuts and Jobs Act of 2017.

This means that for the 2018-2025 tax years, legal fees attributable to punitive damages are entirely non-deductible. A plaintiff who receives $5 million of punitive damages may pay 40% of that amount to their attorney as a legal fee, and they will NOT be able to deduct any of those legal fees on their tax returns. 

This means any plaintiff who receives punitive damages will be taxed on the total amount of punitive damages, INCLUDING the portion paid to the attorney as a contingent fee.

are punitive damages taxable settlement pie chart
are punitive damages taxable settlement tax

Let’s look at a quick example. Assume a plaintiff receives $500,000 in compensatory damages for a personal injury and receives $5,000,000 in punitive damages, and contingent legal fees in the case are 40%. 

When the plaintiff receives the settlement, the plaintiff will not have to pay taxes on the $500,000 because that money is compensatory damages for a personal physical injury. 

However, the plaintiff would have to pay taxes on the full $5,000,000 in punitive damages, even though the plaintiff is likely to only receive $3,000,000 after paying the attorney’s 40% legal fee.

In practice, this means that most of the $5,000,000 awarded as punitive damages will go straight to taxes, and the plaintiff will be left with only a small portion of the $5,000,000 after paying taxes.

One other item of note: In some cases, plaintiffs are also awarded pre- or post-judgment interest along with punitive damages. Pre- or post-judgment interest is always taxable as ordinary income, even if the compensatory damages are tax-free.

To summarize:

  • The IRS doesn’t tax legal settlements that compensate plaintiffs for a personal physical injury.
  • The IRS does tax any amount awarded as punitive damages or pre- or post-judgment interest. 
  • After the Tax Cuts and Jobs Act, plaintiffs cannot deduct their attorney’s fees on the punitive damage portion of the case. 

This can result in a HUGE tax bill without careful planning before settlement.

The high tax bills in these cases can be a gut punch since plaintiffs often don’t expect punitive damages and interest to be taxed. The taxes due on punitive damages or interest can equal or even exceed the entire amount of punitive damages received in a settlement! Imagine getting $5,000,000 in punitive damages just to then pay the entire $5,000,000 to the IRS. That’s painful (and unfair)!

Plaintiff Recovery Trust

What can you do to reduce taxes if your settlement includes punitive damages or interest? 

The best planning tool for cases involving punitive damages or pre- or post-judgment interest is the Plaintiff Recovery Trust.

The Plaintiff Recovery Trust solves the enormous problem created by the Tax Cuts and Jobs Act of 2017. As a reminder, after the Tax Cuts and Jobs Act, plaintiffs cannot deduct legal fees attributable to punitive damages on their tax returns. 

By using the Plaintiff Recovery Trust, plaintiffs CAN avoid paying legal fees on any amount of the settlement given as punitive damages. That’s what makes the Plaintiff Recovery Trust so helpful.

The Plaintiff Recovery Trust allows plaintiffs to ONLY pay taxes on the amount they personally receive and not the entire punitive damage amount.

For example, if there’s $5M of punitive damages in a case and the attorney charges a 40% legal fee, without the Plaintiff Recovery Trust, the plaintiff would pay taxes on the full $5M — even though $2M of that amount is paid to their attorney.

pie chart illustrating the total amount plaintiffs will pay taxes on

With the Plaintiff Recovery Trust, the plaintiff ONLY pays tax on the $3M they actually receive.

Using the Plaintiff Recovery Trust often doubles (or even triples) the amount plaintiffs get to keep after taxes. And it’s the only way plaintiffs receiving punitive damages can avoid being taxed on their attorney’s fees.

In short, the Plaintiff Recovery Trust is a powerful tax planning tool in cases with punitive damages. 

Depending on whether the compensatory damages you receive are tax-free or not, there are additional tax planning strategies we can use to further reduce a plaintiff’s tax bill — check out these other posts for those strategies.

Tax Implications of Punitive Damages: What You Need to Remember

We have covered how punitive damages are taxed — and how the Plaintiff Recovery Trust can dramatically increase a plaintiff’s after-tax net recovery.

The key takeaway: punitive damages, pre-judgment interest, and post-judgment interest are always taxable, and legal fees attributable to punitive damages or interest cannot be deducted. This means that plaintiffs are taxed on the entire amount of punitive damages. However, there is a tax planning strategy — the Plaintiff Recovery Trust — that allows plaintiffs to only pay taxes on the amount of punitive damages left over after their attorneys are paid their fees.

While there are many pitfalls, there ARE ways for plaintiffs to minimize taxes and maximize their take-home recovery. When used correctly, strategies like the Plaintiff Recovery Trust can literally double or triple the net amount plaintiffs get to keep after taxes.

We get it. Settlement taxation can be confusing — and we’re sure you can see why settlement taxes have so many plaintiffs worried and confused. But don’t worry — we are here to help you navigate the complexities of settlement taxation.

If you’re receiving a settlement soon and want to keep more of your hard-won settlement money (especially if you’re receiving punitive damages), my firm is here to help. We offer a free, no-obligation 15-minute phone call for plaintiffs nationwide. Book your consultation now by clicking on the button below.

Everyone who books a call with us receives a 100% customized roadmap showing how much extra money you could keep if you implement the Plaintiff Recovery Trust and other tax planning strategies.

Even if you don’t move forward with our firm, you’ll walk away with invaluable tax education on what to expect when you get your settlement.

Please don’t wait to reach out since ALL the tax planning strategies available to plaintiffs must be set up before you receive the settlement. If you wait until after you receive the settlement, it’s too late, and there’s nothing we can do to reduce your taxes.

So, click the button below to book a call. We look forward to speaking with you soon!

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