Understanding Lost Profits Awards

If your business or property gets taken or damaged and you win a legal case, you might receive money called a “lost profits award.” This is money meant to replace the profits you would have earned if the loss or harm hadn’t happened. But here’s the surprise: that money often isn’t tax-free. State tax laws usually treat a lost profits award as income, just like your regular business earnings. That means you’ll probably owe state taxes on it.

In this guide, you’ll learn how the lost profits award state tax works, why states often tax this money, and what you can do to avoid surprises when tax season arrives. Let’s get started by breaking down the basics.

What Is a Lost Profits Award?

Let’s say your business is forced to close for a few months because the government took your property for a new road. Or maybe another company broke a contract and you missed out on big sales. In both cases, you could sue for lost profits. If you win, the court calculates how much money you would have made and tells the other side to pay you that amount. That payment is called a lost profits award.

It’s different from getting paid for physical damage (like fixing a broken building). Lost profits focus on the income you missed out on, not the cost of repairs or replacement. Courts use financial records, forecasts, and expert testimony to figure out what you really lost. If you’re a business owner or landlord, these kinds of awards can be significant.

Why Are Lost Profits Awards Taxed by States?

Ever wondered why states want a share of your lost profits award? The answer is simple: most states see this money as a replacement for business income. Since normal profits are taxed, the state usually wants to tax lost profits the same way.

Each state sets its own tax rules. In general, if you would have paid tax on the profits if you’d earned them the normal way, you’ll pay tax on a court-awarded replacement. So, if your business is in a state with income tax, expect to report your lost profits award on your state tax return. Some states might have special rules or exemptions, but most don’t treat these awards as special money.

How States Calculate Taxes on Lost Profits Awards

The actual process of taxing a lost profits award depends on your state. Here’s how it usually works:

  1. The award is counted as ordinary income for the year you receive it.
  2. You add the amount to your business or personal income on your state tax return.
  3. The state’s usual tax rate for income applies.

Some states also consider whether the award covers multiple years. If so, you might be able to report it over several years (this is called income averaging), but not every state allows that. If you paid legal fees to win the award, you might be able to deduct some of those costs, but again, this depends on state rules.

Here’s a simple example: If your lost profits award is $50,000 and your state income tax rate is 5%, you’ll owe $2,500 in state tax (not counting possible deductions or credits).

Important Differences Between State and Federal Taxes

It’s easy to confuse state and federal taxes on lost profits awards, but they aren’t always the same. The IRS (the federal tax agency) also usually taxes these awards as ordinary income. However, some deductions or exceptions that exist on your federal return might not apply to your state return. For example, legal fee deductions are sometimes stricter at the state level. Or, your state might not allow you to spread out the income from a big settlement over several years, even if the federal rules do.

The bottom line: don’t assume the state will follow whatever the IRS does. Always check your state’s specific tax rules or talk to a tax professional who knows your local laws.

Steps to Take If You Receive a Lost Profits Award

Getting a lost profits award is good news, but don’t let taxes catch you off guard. Here’s how you can prepare:

  1. Save a portion of your award for taxes. Don’t spend it all right away.
  2. Keep all legal documents, settlement agreements, and calculations from your case. You’ll need these if the state asks for proof.
  3. Work with a tax advisor who understands both state and federal rules. They can help you claim any deductions you’re allowed and avoid penalties.
  4. File your taxes on time and report the award accurately. Mistakes can lead to extra bills or audits.

For example, let’s say you win $75,000 after a business disruption. If you’re not sure how much to set aside, ask a tax expert to estimate your state tax bill. That way, you won’t be surprised by a big payment later.

Common Questions About State Tax on Lost Profits Awards

Is every lost profits award taxable at the state level?

In most states, yes. If your state has an income tax, a lost profits award usually counts as taxable income. There may be rare exceptions, so check your state’s rules.

Can I reduce my state tax bill on a lost profits award?

Sometimes. You may be able to deduct attorney fees or other costs, but deductions vary by state. A tax professional can guide you on what’s allowed.

Do I report the award in the year I receive it, or when the loss happened?

Generally, you report the award in the year you receive the money, not when you suffered the loss. There are exceptions, but this is the usual rule.

Conclusion

Winning a lost profits award can help make up for what you lost, but it often comes with a state tax bill. Understanding how the lost profits award state tax works puts you in control and helps you avoid surprises. Have questions about your unique situation? Contact us to learn more.