Are Malpractice Settlements Taxable Income?

A malpractice settlement provides compensation to an individual harmed by a professional’s negligence or error. Whether this money is taxable depends on the specific nature of the compensation. The Internal Revenue Service (IRS) has distinct rules for different parts of a settlement award.

The General Rule for Physical Injuries and Sickness

The foundation of settlement taxation is found in Internal Revenue Code Section 104. This rule states that compensation received for personal physical injuries or physical sickness is not included in your gross income. The payment is intended to restore you to the position you were in before the injury, rather than generating new income, making that portion of the award tax-free.

This tax-free treatment also extends to compensation for pain, suffering, and emotional distress, but only if that distress originates from the physical injury or sickness. For example, if a surgical error leads to a chronic physical condition and subsequent anxiety, the compensation for both the physical ailment and the resulting emotional distress would be excluded from taxation. The direct link between the emotional suffering and a physical harm is the determining factor.

The settlement agreement should clearly designate the purpose of the funds. Attorneys often structure agreements to explicitly state that payments are for physical injuries and sickness. This documentation is valuable if the IRS questions the nature of the settlement, as it helps prove the non-taxable status of the funds.

Taxable Components of a Settlement

Punitive Damages

Punitive damages are treated differently from compensation intended to make you whole. These damages are not meant to compensate you for a loss but to punish the wrongdoer for egregious behavior. Because they go beyond restoring your prior condition, the IRS considers punitive damages to be income. Any portion of a settlement allocated to punitive damages is taxable and must be reported as “Other Income,” even if the lawsuit’s origin was a physical injury.

Lost Wages

If your settlement includes an amount to replace income you could not earn due to your injury, that portion is taxable. The logic is that wages would have been taxed as ordinary income if you had been able to work, so the settlement portion that replaces them is subject to the same treatment. This compensation for past or future lost income must be reported, and the payer may withhold income and employment taxes from this part of the settlement.

Interest

In some cases, a settlement award may accrue interest, especially if there are delays between the agreement and the actual payment. Any interest paid on the settlement amount is considered taxable interest income. The payer will issue a Form 1099-INT to you and the IRS detailing the interest you received.

Emotional Distress without Physical Injury

The tax rules make a sharp distinction for emotional distress damages that do not stem from a physical injury. If a malpractice case is based solely on emotional or mental anguish without an accompanying physical harm, any compensation received for that distress is considered taxable income. For these damages to be tax-free, they must be a direct consequence of a physical injury or sickness, as established in the general rule.

Special Tax Considerations

Reimbursement for Medical Expenses

The tax treatment for reimbursed medical expenses depends on your prior tax filings. If you claimed medical costs as an itemized deduction on a previous tax return, the portion of your settlement that reimburses you for those expenses is taxable. This is due to the tax benefit rule, which states you must report income when you recover an amount you previously deducted, limited to the extent the deduction provided a tax benefit.

Conversely, if you paid for medical expenses out-of-pocket but did not deduct them, the reimbursement you receive for those costs is not taxable. In this scenario, the payment is simply restoring your own funds and is not considered income. This underscores the importance of tracking whether medical costs related to the injury were previously deducted.

Tax Treatment of Attorney’s Fees

How attorney’s fees are handled affects your taxable income. The IRS considers a taxpayer to have received the full, gross amount of the settlement, even if a portion is paid directly to their attorney. For example, if you are awarded a $200,000 taxable settlement and your attorney’s fee is 40% ($80,000), the IRS views you as having received the entire $200,000.

The Tax Cuts and Jobs Act of 2017 (TCJA) suspended miscellaneous itemized deductions for individuals through 2025. Since legal fees for most personal injury cases fall into this category, you cannot deduct the attorney’s fees paid. This means you could be required to pay taxes on the full settlement amount, including the portion that went to your lawyer, without a corresponding deduction.

Reporting Settlement Income

Once you determine which portions of your settlement are taxable, you must report them correctly. The payer of the settlement may send you and the IRS informational tax forms. For instance, you might receive a Form 1099-MISC for taxable damages, such as punitive damages or lost wages not subject to employment tax withholding, which are reported as “Other Income” on Schedule 1 of your Form 1040.

If your settlement included taxable interest, the payer should issue a Form 1099-INT. This interest income is reported on the designated line for taxable interest on your Form 1040. You must match the amounts on these forms with what you report on your tax return, as the IRS uses them for verification.

Failing to report taxable settlement proceeds can lead to penalties and interest charges from the IRS. Given the complexities, consulting the settlement agreement and a tax professional can help ensure accurate reporting.