Are Legal Damages Taxable? What the EDO–iSpot Verdict Means for Businesses

Hook: The $18.3M Wake-Up Call for Businesses

Large verdicts and settlements are business events that create real cash — and real tax questions. If your company were handed an unexpected $18.3 million award like iSpot’s judgment against EDO, would your accounting, tax reporting, and audit file be ready? Many finance leaders and tax teams are surprised to learn that not all legal recoveries are taxed the same way. Getting the classification and documentation wrong can trigger audits, penalties, and lost tax benefits.

Quick answer: Are legal damages taxable?

Short version: Most business-related legal recoveries are taxable, but the tax treatment depends on the type of damage, how the recovery is allocated in the agreement, and what the recovery replaces. Physical injury awards may be excluded in limited cases (mostly for individuals), while punitive damages and awards for lost profits are generally taxable. Attorney-fee treatment and state tax rules complicate the picture.

Why the EDO–iSpot $18.3M verdict matters for tax planning

In January 2026, a jury awarded iSpot $18.3 million after finding EDO breached a contract related to TV advertising measurement data. The award illustrates two practical realities tax teams face:

• Many commercial damages (contract breaches, lost profits, business torts) are taxable income to the recipient.
• How the judgment is described and allocated in the judgment or settlement agreement can materially change tax outcomes.

“We are in the business of truth, transparency, and trust… Rather than innovate on their own, EDO violated all those principles, and gave us no choice but to hold them accountable,” an iSpot spokesperson said.

Tax categories: How different recoveries are treated in 2026

Below is a practical breakdown of common categories that frequently occur in business litigation and their usual federal tax treatment. Cite IRC sections in your file — 26 U.S.C. §61 (gross income), §162 (trade or business deductions), §104 (certain injury exclusions) — and IRS guidance (see Publication 525) when you prepare returns.

1. Compensatory damages for lost profits or income

Treatment: Taxable as ordinary income when received. These recoveries replace lost revenue and are treated like the income they compensate.

Practical tip: If the award reimburses amounts that were previously deducted (for example, you deducted a business expense in an earlier year and now get paid back), you may need to include that recovery in income or adjust basis under the tax benefit rule.

2. Compensatory damages for property loss or damage

Treatment: Usually reduces the tax basis of the damaged property. If the award exceeds the adjusted basis, the excess is treated as gain (taxable). If the recovery only repairs or replaces the property, it may not be taxable income.

3. Punitive damages

Treatment: Taxable in full. Punitive damages punish the defendant and are not considered compensation for lost income or injury for tax exclusion purposes.

4. Emotional distress and non‑physical injury

Treatment: For individuals, emotional distress awards are generally taxable unless they originate from a physical injury or physical sickness. For businesses, emotional distress rarely applies; related amounts will generally be treated as taxable income.

5. Interest on the award

Treatment: Interest included in a damages award is taxable as ordinary interest income and reported separately from the principal award. The IRS pays close attention to the portion of any payment that is interest.

6. Attorney’s fees

Treatment: Complex. The attorney’s fee is income to the attorney. For the payer (the defendant), attorney-fee payments that are part of a settlement are generally deductible under 26 U.S.C. §162 if they are ordinary and necessary business expenses. For the payee (the plaintiff), whether the plaintiff can deduct attorney’s fees depends on the nature of the claim and the availability of deductions (individuals face different rules than businesses).

Important: Tax rules changed after the Tax Cuts and Jobs Act (TCJA), and the expiration of some TCJA provisions at the end of 2025 affects individuals’ deductibility of certain fees for the 2026 tax year. Businesses should coordinate with counsel and tax advisors to determine whether fees are deductible as business expenses or capitalized.

Applying this to the EDO–iSpot case

iSpot’s $18.3M award arose from a finding of contract breach concerning business data access and misuse. That type of recovery looks like compensatory damages for lost business value or lost profits, which means it will generally be taxable to iSpot as ordinary income when recognized.

Key reasons:

• The damages replace a business loss (not personal physical injury).
• Any punitive component (if the jury had included such an award) would be taxable as well.
• Interest accrued from the date of harm to judgment will be taxable if included in the judgment.

Practical steps businesses should take when you win (or pay) a large award

Whether you are the payor (EDO) or the recipient (iSpot), these are the practical, audit‑oriented steps to take immediately. Follow this checklist to reduce ambiguity and preserve tax positions.

1. Insist on a written allocation in the judgment or settlement

Why: A clear allocation between lost profits, emotional distress, property damage, punitive damages, and interest materially affects tax treatment.

Action: Negotiate and include a specific allocation clause. If you represent the recipient, push for an allocation that minimizes tax exposure (but ensure it’s supportable). If you’re the payor, be aware an aggressive allocation could trigger later adjustments.

2. Capture supporting documentation contemporaneously

• Damage calculations and models used at trial
• Communications regarding the agreement and allocation
• Invoices, receipts, and prior-year tax returns showing previously deducted amounts

Action: Maintain a dedicated settlement file with signed agreements, court orders, and counsel’s tax analysis. This is essential for audit defense.

3. Assess accounting vs. tax treatment

Under GAAP, proceeds may be presented as other income or adjust prior period expenses. For tax purposes, classification dictates whether to report as ordinary income, capital gain, or basis adjustment.

Action: Have finance and tax teams jointly document the GAAP presentation and the tax treatment rationale.

4. Determine treatment of attorney’s fees and gross‑up clauses

Contingent-fee arrangements can create a mismatch: the recipient may have to include the full award in income but cannot always deduct the attorney’s share because of deduction limitations. A gross-up clause (where the defendant pays the plaintiff’s attorney fees) may create additional tax consequences.

Action: Run scenarios with counsel — consider structuring payments through a Qualified Settlement Fund (QSF) under IRC §468B if multiple claimants or timing considerations exist.

5. Estimate and remit tax payments quickly

Large taxable awards can create quarterly estimated tax obligations for recipients and may trigger withholding or reporting duties for payors. Interest components require separate reporting.

Action: Calculate expected federal and state taxes and make estimated tax payments to avoid underpayment penalties. Communicate with payroll and accounts payable teams if any withholding or reporting is required for the payor.

6. Evaluate state and international tax consequences

State tax rules vary significantly. Some states follow federal treatment; others do not. Cross-border claims can create source issues and withholding obligations on foreign recipients.

Action: Engage state tax leads and international tax counsel early to assess nexus, sourcing, and withholding liabilities. For cross-border digital claims, see our digital-economy primer.

7. Prepare an audit‑ready memo

Document your position: the facts, legal basis, allocation, GAAP and tax treatment, counsel opinions, and calculations. Retain calculations used in trial and any settlement negotiations that support your allocation.

Action: Create a concise audit memo to include in the tax workpapers.

Accounting and journal entry examples (simple illustrations)

Below are two simplified entries to show how a recipient and payor might record a judgment. Always tailor entries to your chart of accounts and consult with your auditor.

Recipient (iSpot) — $18.3M judgment allocable as $17M lost profits + $1.3M interest

1. To record cash receipt:
   • Dr Cash $18,300,000
   • Cr Other income — litigation recovery $17,000,000
   • Cr Interest income $1,300,000
2. To record income tax reserve (estimate):
   • Dr Income tax expense $X
   • Cr Income tax payable $X

Payor (EDO) — $18.3M judgment expense

1. To record settlement obligation:
   • Dr Litigation loss/settlement expense $18,300,000
   • Cr Cash $18,300,000
2. To reflect potential tax deduction (subject to tax analysis):
   • Dr Deferred tax asset (if applicable) $Y
   • Cr Income tax benefit $Y

2026 trends tax teams must know

Several developments entering 2026 change the playing field for settlement and award taxes:

• Post‑TCJA expirations (end of 2025): The expiration of certain TCJA provisions affects individual deductibility of some legal fees and may revive previously suspended deductions for 2026. Businesses should confirm current law for the tax year of the award. See related regulatory shifts.
• IRS data analytics and audits: The IRS has increased focus on large, one‑time items of income (including settlements), especially in tech/adtech sectors. Expect heightened scrutiny of allocations and documentation; modern oversight increasingly resembles observability-driven review workflows.
• Cross-border and digital economy complexity: As more disputes involve data, SaaS, and adtech (the exact area of iSpot vs EDO), characterizing the source of damages (U.S. vs foreign) has become more important for withholding and state apportionment. Our digital economy coverage explains common cross-border pitfalls.
• Settlement structuring sophistication: Parties increasingly use QSFs, escrow structures, and specific tax gross-up language to manage tax timing and withholding. Expect defendants to negotiate allocations to manage their deduction profiles.

Common audit triggers and how to avoid them

The IRS and state tax authorities look for red flags. Prevent avoidable challenges by taking these steps:

• Don’t treat a single payment as ambiguous — document its nature and allocation at signing.
• Retain damage calculations, expert reports, and any models used to justify amounts.
• If you receive a settlement in installments, track the tax year in which each payment is includible.
• Save correspondence showing the business reason for the claim — courts and auditors want to see economic substance.

Real-world checklist: What your tax team should do in the first 30 days

1. Obtain the signed judgment or settlement and confirm allocation language.
2. Request a tax memorandum from litigation counsel explaining recommended treatment.
3. Run a tax impact model (federal + state) and set aside estimated taxes.
4. Decide whether to use a QSF or escrow for payment timing and reporting.
5. Document GAAP vs tax positions and prepare an audit memo for the file.
6. Communicate with investor relations and auditors about material disclosures.

When to bring in outside specialists

Large or complex awards demand specialized help. Consider outside experts when any of the following exist:

• Cross-border parties or payments
• Complex allocation disputes between compensatory and punitive elements
• Significant attorney-fee arrangements or contingent fee structures
• Potential for material restatement or tax shelter risk

Engage tax counsel, forensic accountants, and valuation experts early to support a defensible position. If the award touches digital platforms or payment rails, coordinate with teams familiar with the digital-payments landscape.

Bottom line: Treat judgments like taxable events — prepare and document

Large awards like the iSpot $18.3M verdict are not one-off windfalls to be treated casually. For most businesses, the default position is that commercial recoveries are taxable. The difference between a taxable recovery and a nontaxable one usually hinges on a few documents: the judgment or settlement agreement, the supporting damage calculations, and contemporaneous advice from tax counsel.

When in doubt, assume the tax authority will ask for proof. Invest the time to document the why and how — your audit file is your strongest defense.

Actionable takeaways

• Negotiate allocations: Ensure settlement agreements explicitly allocate amounts among lost profits, property damage, punitive damages, attorney fees, and interest.
• Document everything: Preserve expert reports, models, and correspondence that support your damage calculations.
• Estimate taxes now: Make estimated tax payments on large awards to avoid penalties.
• Coordinate internal teams: Get tax, finance, legal, and external auditors aligned before filing returns.
• Consult specialists: Use QSFs, valuation experts, or tax counsel for complex, multijurisdictional claims.

Next steps — get audit‑ready

If your company faces litigation or a large award is pending, don’t wait until year-end. Use our audit-preparedness checklist and template settlement allocation clause to lock in the tax treatment you need. A well-documented position can save millions in tax leakage and reduce audit risk.

Call to action: Download our free Settlement & Award Tax Checklist and get a 30‑minute consultation with an incometax.live tax specialist to review your settlement language and tax strategy for 2026. Protect your company’s bottom line before you cash the check.

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