Ever wondered how the IRS taxes money you get from a lost profits award? The answer isn’t always obvious, but it can have a real impact on your tax bill. Whether a lost profits award is classified as a capital gain or ordinary income may change how much tax you pay, and how you report it. In this guide, you’ll learn what lost profits awards are, how the IRS makes its decision, and what it means for your taxes. We’ll walk through the basics in plain English, using real-world examples and clear steps so you know what to expect if you ever receive a lost profits award.

What Is a Lost Profits Award?

A lost profits award is money you receive to make up for profits you didn’t earn because of someone else’s actions. This often happens after a lawsuit or settlement when your business or personal finances are harmed. For example, if a company damages your equipment and you can’t operate for a week, you might get a court-ordered payment to cover the profits you lost during that downtime. These awards are common between businesses, but individuals can get them too, imagine a freelance designer who loses work due to a client’s broken promise.

The big tax question is this: Once you receive a lost profits award, is it taxed like a paycheck (ordinary income) or like the profit from selling an investment (capital gain)? The answer affects your tax rate and how you need to report the money to the IRS.

Understanding Capital Gain vs. Ordinary Income

The IRS recognizes two main types of income: ordinary income and capital gain. Here’s how they differ:

  1. Ordinary income is what you get from working, running a business, or providing services. Wages, business profits, and interest all count as ordinary income. This type of income gets taxed at your regular income tax rate, which can be as high as 37% for high earners.

  2. Capital gain is the profit you make when you sell something (like stocks, real estate, or a business asset) for more than you paid for it. Capital gains are taxed at lower rates if you held the asset for more than a year, typically 0%, 15%, or 20%, depending on your income.

So, if your lost profits award is treated as ordinary income, you’ll likely pay more in taxes than if it qualifies as a capital gain. But what does the IRS look at to make this decision?

How the IRS Decides: Key Factors for Lost Profits Awards

The IRS cares most about what the lost profits award is meant to replace. Is the money replacing business income you would have earned, or is it making up for the value of a lost or damaged asset?

If the money is meant to replace profits from your regular business operations, the IRS almost always treats it as ordinary income. For example, if your bakery has to close for two weeks because of a water leak caused by a neighbor, and you win money in court to cover the sales you missed, that’s ordinary income. It’s taxed just like the profits you normally earn from baking and selling bread.

If the award is for the destruction or loss of a capital asset, something you own for investment, like property, a building, or equipment, the payment could be taxed as a capital gain. Here, the IRS looks at whether the award is compensating you for the value lost in the asset itself. This can get complicated, especially when a payment includes both lost profits and damage to assets. The IRS doesn’t just look at the label, how the settlement or judgment is worded and what the payment is for are both critical.

Sometimes, an award or settlement will have a mix of different types of payments. It’s possible for part of your award to be taxed as ordinary income and another part as capital gain. For example, if you lose part of your property to the government through eminent domain and also lose some business income as a result, the property loss may be a capital gain while the lost business income is ordinary income.

Examples: How Lost Profits Awards Are Taxed

Let’s look at a few practical scenarios to see how these rules play out.

Imagine a small store owner whose business is disrupted by road construction that blocks customer access for three months. They sue and receive a payment equal to the profits lost during the closure. Since the award is replacing business income, it’s taxed as ordinary income. The store owner must report it just like any other business earnings, and it could push them into a higher tax bracket for the year.

Now, picture a landowner whose property is partially taken by the government for a new highway. The payment they receive for the loss in property value is usually considered a capital gain, because it’s tied to the sale or loss of a capital asset (the land itself). If the payment is more than what they originally paid for that part of the land, the difference is taxed as a capital gain. However, if the settlement also includes compensation for lost rental income during construction, that portion is taxed as ordinary income.

Another example: Suppose you own a factory, and a fire caused by a neighboring business shuts you down for a month. The court awards you money for lost production during that period, plus the cost to repair your building. The lost production payment is ordinary income, while the money for building repairs may not be taxable if you use it to fix the property, or it could affect your capital gains calculation when you sell the building later.

Why the Distinction Matters for Your Taxes

The difference between capital gain and ordinary income is more than just a label, it can have a big impact on your tax bill. Ordinary income is taxed at rates that range from 10% to 37%, depending on your total income. Capital gains, especially long-term capital gains (for assets held more than a year), are generally taxed at lower rates: 0%, 15%, or 20%.

That means if your lost profits award is classified as ordinary income, you could owe a lot more in taxes than if it’s a capital gain. For business owners or anyone with a large award, this can make a big difference in how much of the money you actually keep.

If you get a lost profits award, it’s essential to know what the payment was for and how it’s described in any settlement or court document. When in doubt, ask for a clear breakdown. The IRS may request documentation, especially if the numbers are significant or if the award is split between different types of compensation.

What Should You Do If You Receive a Lost Profits Award?

If you’re awarded money for lost profits, here are some steps to make sure you handle the tax side correctly:

  1. Carefully review the settlement agreement or court judgment. Look for specific wording about what the payment is meant to replace, lost business income, property damage, or something else. If the agreement is vague, ask for clarification in writing.