Are Lawsuit Proceeds and Settlements Taxed by the IRS?

The Internal Revenue Service (IRS) does not apply a uniform tax rule to all lawsuit settlements and awards. The specific tax treatment depends significantly on the nature of the claim that led to the settlement or judgment. The overall taxability hinges on what the payment is intended to replace or compensate the recipient for, rather than simply the source of the payment itself.

Understanding the General Rule for Taxability

The fundamental principle guiding the taxability of lawsuit proceeds is often referred to as the “origin of the claim” doctrine. This doctrine dictates that the tax character of a settlement or award is determined by the nature of the underlying item for which the compensation is provided, not by the legal action itself. If the payment is a substitute for income that would normally be taxable, then the settlement amount generally remains taxable. Conversely, if the payment compensates for something that would not typically be considered income, it may be excluded from gross income.

For example, if a lawsuit award compensates an individual for lost wages due to an employer’s breach of contract, that portion of the award is typically taxable because wages are normally taxable income. However, if the award is for damages related to a personal physical injury, which is generally not considered income, that portion may be non-taxable. The IRS generally looks at the reason for the payment, rather than the form it takes, to determine its tax treatment.

Taxable Categories of Lawsuit Awards

Many types of lawsuit awards are generally considered taxable income by the IRS because they compensate for items that would otherwise be subject to tax. Awards for lost wages or lost profits, for instance, are fully taxable.

Punitive damages, which are awarded to punish the wrongdoer rather than compensate the injured party, are almost always taxable. This rule applies regardless of whether the underlying claim involved physical injury or not. Interest awarded on any type of damages is also fully taxable, as interest income is generally subject to tax under federal law.

Emotional distress damages are taxable unless they are directly attributable to a physical injury or physical sickness. For example, if emotional distress arises from discrimination without any accompanying physical harm, the compensation for that distress is typically taxable. Furthermore, damages received for injury to reputation, such as defamation, are generally taxable income.

Non-Taxable Categories of Lawsuit Awards

Certain categories of lawsuit awards are generally excluded from gross income under federal tax law. The most common exclusion applies to damages received on account of personal physical injuries or physical sickness. This means that compensation for medical expenses, pain and suffering, and lost wages directly resulting from a physical injury or illness are typically not taxable.

For this exclusion to apply, the injury or sickness must be physical in nature. Emotional distress damages are also non-taxable if they are directly linked to a physical injury or physical sickness. However, if emotional distress is not connected to a physical injury or sickness, the damages received for it are generally taxable. Reimbursements for medical expenses, regardless of whether they are part of a larger settlement or a standalone payment, are also typically non-taxable.

The Tax Treatment of Legal Fees

The tax treatment of legal fees incurred in a lawsuit can significantly impact the net amount an individual receives from a settlement or award. Generally, legal fees are not deductible by individuals as a miscellaneous itemized deduction. This change resulted from the Tax Cuts and Jobs Act of 2017, which suspended miscellaneous itemized deductions subject to the 2% adjusted gross income (AGI) limit for tax years 2018 through 2025.

In many personal physical injury cases, legal fees paid under a contingency fee arrangement may not be included in the plaintiff’s gross income, even if the attorney receives a portion directly from the settlement. However, for taxable awards, such as those for lost wages or punitive damages, the entire amount of the award is generally considered income to the plaintiff, even if a portion is paid directly to their attorney under a contingency fee agreement. This means the plaintiff must report the full taxable amount of the award as income, even though they only physically received a reduced amount after legal fees. In some specific circumstances, primarily involving claims of unlawful discrimination or certain whistleblower actions, an above-the-line deduction for attorney fees and court costs may be permissible, reducing the taxpayer’s AGI.

Reporting Requirements for Lawsuit Proceeds

When lawsuit proceeds are considered taxable, the payer often has reporting obligations to the IRS. For many types of taxable settlements, particularly those for non-employee compensation, rents, or other income, the payer will issue Form 1099-MISC, Miscellaneous Income, or Form 1099-NEC, Nonemployee Compensation. For example, if a settlement includes lost wages from an employer, the employer might report these amounts on a Form W-2, Wage and Tax Statement, as if they were regular wages.

The individual receiving the settlement is responsible for accurately reporting the taxable portion of the proceeds on their federal income tax return. The information reported on Forms 1099-MISC or 1099-NEC will typically be entered on Schedule 1 (Form 1040), Additional Income and Adjustments to Income. Consulting with a tax professional is highly recommended to ensure proper reporting and to understand any potential deductions or exclusions that may apply to the specific circumstances of the award.