Are Settlements Taxed? What the IRS Considers Income
Understand the IRS's perspective on settlement funds. Navigate the tax landscape to properly account for your received settlement.
Whether a settlement is subject to taxation is a common concern for individuals receiving funds from legal claims. The tax treatment of settlement proceeds depends primarily on the underlying reason for the payment, rather than the nature of the lawsuit itself. The Internal Revenue Service (IRS) generally considers all income taxable unless a specific exclusion is provided by law.
Understanding Taxable Settlement Income
Certain types of settlement payments are considered taxable income. This includes compensation intended to replace income, such as lost wages or lost profits. If a settlement resolves an employment dispute and includes an amount for past or future earnings, that portion is taxed as ordinary income.
Damages received for emotional distress are taxable if the distress is not directly caused by a physical injury or physical sickness. For example, a settlement for defamation that includes compensation for emotional suffering, where no bodily harm occurred, is considered gross income.
Punitive damages, awarded to punish the wrongdoer rather than to compensate for actual losses, are fully taxable. The IRS views these as a form of income without a specific statutory exclusion.
Any interest accrued on a settlement amount is subject to taxation. This interest is considered ordinary income, similar to interest earned from other investments. The timing of when the interest accrues does not alter its taxable nature.
Compensation for harm to reputation is taxable settlement income, unless directly linked to a physical injury. For example, if a settlement includes funds for damage to a business’s reputation not resulting from physical harm, those funds are taxable.
When a settlement is taxable, the entire gross amount, including any portion paid directly to attorneys, is considered income to the recipient for tax purposes. This means the taxpayer must account for the total sum before any deductions.
Identifying Tax-Exempt Settlement Income
Certain settlement proceeds are exempt from federal income tax. The most significant exclusion applies to damages received on account of physical injuries or physical sickness. This means compensation for medical expenses, pain and suffering, or other losses directly resulting from a physical injury or illness is not subject to taxation.
To qualify for this exclusion, the injury or sickness must be discernible bodily harm or a diagnosed physical ailment, not merely emotional distress or reputational damage. For example, a settlement for injuries sustained in a car accident, including amounts for hospital bills and lost limbs, is tax-exempt.
Emotional distress damages can also be tax-exempt if directly attributable to a physical injury or physical sickness. For instance, if a person experiences severe emotional distress as a direct consequence of a physical assault or a debilitating illness, the portion of a settlement allocated to that emotional distress is excluded from income.
Another category of tax-exempt settlement income involves the return of capital. If a settlement compensates for a loss in the value of property, the portion of the settlement that restores the original cost or “basis” of that property is not taxed.
Any amount received in a settlement that exceeds the original basis of the property is considered a taxable capital gain. For example, if a property with an original cost of $100,000 is damaged and a settlement of $120,000 is received, the first $100,000 is a tax-free return of capital, while the remaining $20,000 is a taxable capital gain.
Reporting Settlement Income to the IRS
Understanding the specifics of your settlement agreement is the first step in reporting income to the IRS. The agreement outlines the allocation of funds to different types of damages, such as physical injury, lost wages, or punitive damages. This allocation dictates which portions of the settlement are taxable and which are exempt.
Recipients of taxable settlement income receive various information forms. For example, taxable settlement income not related to employment, such as for emotional distress not linked to physical injury or punitive damages, is reported on Form 1099-MISC, Miscellaneous Information. This amount is found in Box 3, labeled “Other income.”
If a settlement includes back wages or other employment-related income, it is reported on a Form W-2, Wage and Tax Statement. This form indicates that the income is subject to withholding for federal income tax, Social Security, and Medicare taxes, similar to regular wages.
When reporting taxable settlement income on your federal income tax return, Form 1040, the placement depends on the nature of the income. Lost wages and other employment-related income reported on a Form W-2 are entered on Line 1 of Form 1040, under “Wages, salaries, tips.” Taxable emotional distress damages or punitive damages, reported on Form 1099-MISC, are reported on Schedule 1, Additional Income and Adjustments to Income, on Line 8z, labeled “Other income.”
Taxable interest received on a settlement is reported on Schedule B, Interest and Ordinary Dividends, if the amount exceeds a certain threshold or if you have other interest income. From Schedule B, the total taxable interest is then transferred to Form 1040.
In situations where a single Form 1099-MISC includes both taxable and non-taxable components, such as a settlement covering both physical injury damages and punitive damages, the full amount shown on the 1099-MISC must initially be reported. The non-taxable portion is then subtracted, with a clear explanation provided to the IRS.