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MequonCPA, Certified Public Accountant (CPA)
Category: Tax
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Experience:  CPA, Over 30 yrs experience w/individuals and small businesses. Masters in Tax.
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We own two S corps (Missouri). They are franchises. We sued

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We own two S corps (Missouri). They are franchises. We sued for breach of contract of the franchise agreements and just settled out of court. In general, are the settlement proceeds taxable income to the S corp? How do we go about establishing that some of the settlement was for personal injury (emotional distress for driving us out of business, etc.)
Thanks for asking your question! I'm sorry to hear about your tax issue and I'm going to try my best to help you understand or resolve it.

Compensatory damages are not taxable, whereas punitive damages are taxable. The court will define what the damages are attributed to. Compensatory damages are damages that make you whole again - that is, they put you back to where you were or would have been had the breach of contract never happened. Punitive damages are damages that the court awards to punish the offending party. Again, the judge's decision should define these.

An S-corp is a pass through entity meaning the S-corp itself doesn't pay any tax. Tax is paid at the shareholder level, with each shareholder paying tax on his/her share of income. If the damages were awarded to the SCorp and the shareholders were not named personally in the award, there's no way to "allocate" losses to a shareholder other than through passing the income through on the tax return.

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Hi and welcome to JustAnswer:

Different expert here. It is unlikely that any of the damages you received would be classified as "personal injury". Only compensatory damages received for personal injury are exempt from tax. Yes, you endured emotional stress, but the lawsuit related to your business contract not medical harm. Thus all of the proceeds will be income to the corporation. It may be capital gain if you received them in exchange for a franchise which you no longer have.

MequonCPA, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 2342
Experience: CPA, Over 30 yrs experience w/individuals and small businesses. Masters in Tax.
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Customer: replied 4 years ago.

For My Virtual CPA: it wasn't a court judgment; it was a pre-trial settlement. Thus, no guidance or definition from the court on 'type' of award (compensatory vs punitive). We'd like to declare some of the settlement as capital gains and the franchisor purchasing goodwill by buying back the franchises. Is that a valid approach?

Hi -

Without having the full details it is difficult to determine how or if you can allocate the settlement. Based on the limited information available it seems you may be able to support at least a partial allocation to capital gains. You should review the original contract and the wording of the settlement with your tax counsel and accountant to determine the best course of action.