TAX LOSS CONSEQUENCES
Investors who receive monetary damages from a securities dispute must determine how to report the money on their tax returns. The income may be characterized as ordinary income, capital gain, nontaxable return of capital or fully taxable punitive damages. The taxation of damage awards requires a deep understanding of IRS rulings. We do not intend this in any way to be construed as tax advice. Always seek the counsel of a certified public accountant or other tax professional before filing your tax returns. Here are some relevant rules that provide guidance for investors who have successfully recovered their stock or investment losses.
The tax treatment of damages received from securities investment disputes depends entirely on how the investor classifies the nature of the damages. In disputes between the stockbroker and/or the brokerage company, defendants frequently attempt to pay damages without admitting wrongdoing resulting in the recipients left without any documentation as to the nature of the damages. Proper documentation is required when classifying damage awards as (lost income, return of capital, capital gain or punitive) to substantiate a subsequent tax treatment if the IRS brings a challenge.
If there is a final judgment or settlement agreement that indicates what specifically the damages represent, courts will typically hold that the allocations contained in the settlement agreement or award are binding for tax purposes. A taxpayer is better off classifying the award as a nontaxable return of capital than as opposed to punitive damages or lost income which will be taxed as ordinary income.
Lawyers need to be cautious when negotiating settlement agreements, because the IRS is not required to accept settlement-agreement allocations. An allocation in a settlement agreement will only be upheld on review if it was negotiated in good faith.
A settlement agreement should be consistent with the original Statement of Claim. If a complaint sought lost profits and punitive damages, the investor may be challenged by the IRS for recharacterizing the damages as nontaxable return of capital in a later settlement stipulation.
Some courts treat tax damages received by award in the same manner as the items they are intended to replace. Damages received as a result of lost interest and dividend income on an investment are classified as ordinary income. Damages received for harm to capital assets (securities investments) are nontaxable to the extent of the plaintiff's basis in the capital asset and are capital gain to the extent they exceed basis.
Investors who are not successful in securing a damage award or settlement stipulation still have the option to deduct investment losses on their taxes. However, the value of the deduction is restricted by the $3,000 limit that applies to net capital losses. If investors can characterize their losses as theft (casualty) then the losses are fully deductible against other income. To characterize a loss as theft is difficult, because this require the taxpayer to show that the taking of the property was done with criminal intent in an illegal manner. To take the theft loss due to your stockbroker’s actions you must show that your broker acted with criminal intent. If you were involved in a clearly fraudulent scheme such as "Ponzi" schemes, then you are entitled to a theft deduction.