Are penalties from a lawsuit settlement taxable at federal and state (California) levels? The lawsuit is about employees being overworked and not paid overtime. Of the settlement amount, 50% is W2 income,
35% penalty, 15% interest. Want to know because if the penalty is taxable, then my income would be higher, and to avoid tax penalties for underpayment of tax I'd either have to make estimated payments or take advantage of the prior year safe harbor rule (this year's W2 tax
110% of last year's total tax, though 100% for lower incomes).
Most states start with Federal AGI and work from there. If yours is one of them, check the "Adjustments to Federal AGI" section of the instructions to see if there's a way to back it out on your state return. It's probably also taxable for the state.
The U.S. Supreme Court squarely addressed the taxability of punitive damages in O'Gilvie v. United States, 519 U.S. 79 (December 10, 1996).
The question before the Court was: Does the exclusionary provision of 26 USC section 104(a)(2), which excludes from gross income the "amount of any damages received... on account of personal injuries or sickness," apply to punitive damages received by a plaintiff in a tort suit for personal injuries?
The Supremes answered the question as follows in a 6 - 3 ruling:
No. In a 6-3 opinion delivered by Justice Stephen G. Breyer, the Court held that the punitive damages received by the O'Gilvies were not received "on account of" personal injuries," and therefore the provision did not apply and the damages were taxable. Agreeing with the Government's definition, Justice Breyer reasoned that the exclusionary provision applied to those personal injury lawsuit damages that were awarded by reason of, or because of, the personal injuries, and not to punitive damages that do not compensate injury, but are private fines to punish and deter reprehensible conduct. Justice Antonin Scalia, who was joined by Justices Sandra Day O'Connor and Clarence Thomas, dissented.
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================ In light of the above ruling by the highest court in the land, the taxability of punitive damages is a settled issue of law.
I can't speak confidently about California law but I strongly suspect they follow the feds on this issue.
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