Do I Pay Taxes on a Lawsuit Settlement?

Understanding the tax implications of a lawsuit settlement is important, as its taxability is complex. The determination hinges significantly on the “nature” or “origin” of the claim that led to the settlement. Different components within a single settlement can be treated distinctively for tax purposes.

Determining Taxability of Settlement Components

Generally, all income received from any source is considered taxable unless a specific exclusion is provided by law. This broad rule, outlined in Internal Revenue Code (IRC) Section 61, applies to lawsuit settlements as well. However, IRC Section 104 offers specific exclusions for certain types of damages received from lawsuits, settlements, and awards.

Damages received due to personal physical injuries or physical sickness are excluded from gross income under IRC Section 104. This exclusion applies to compensation for bodily harm, such as injuries from car accidents, slip and falls, or medical malpractice. It also covers medical expenses incurred as a result of the physical injury or sickness, provided these expenses were not previously deducted. Emotional distress damages are also non-taxable if they are directly attributable to a physical injury or sickness. For instance, if emotional distress arises from a physical injury, it is considered an extension of that injury and is not subject to taxation.

Conversely, many other types of damages are taxable. Emotional distress damages are taxable if they do not originate from a physical injury or sickness. For example, compensation for emotional distress in cases of defamation or discrimination without physical harm would be subject to tax.

Lost wages, lost profits, or loss of business income received as part of a settlement are always taxable. These amounts are treated as regular income and may be subject to income, Social Security, and Medicare taxes. Punitive damages, which are awarded to punish a defendant rather than to compensate for a loss, are always taxable. This applies even if they are received in a case involving physical injury, as they are not considered compensatory.

Any interest earned on a settlement award is also fully taxable. This interest is viewed as regular income. Damages for claims such as wrongful termination, discrimination (unless tied to a physical injury), or breach of contract are taxable. The IRS looks to the “origin of the claim” to determine taxability, meaning the reason for the payment dictates its tax treatment, not just the label given by the parties.

Common Deductions and Adjustments

When a portion of a lawsuit settlement is taxable, understanding how attorney fees and other expenses are treated for tax purposes is important for the net taxable amount. Attorney fees related to taxable settlements were deductible as miscellaneous itemized deductions. However, the Tax Cuts and Jobs Act (TCJA) suspended these deductions through 2025 for most individual taxpayers.

An exception exists for attorney fees incurred in specific types of cases. Attorney fees and court costs paid in connection with claims of unlawful discrimination, certain whistleblower claims, and specific civil rights violations can be deducted as an adjustment to income. This deduction is taken directly from gross income, avoiding itemized deduction limitations. The deduction for these specific claims is limited to the amount of taxable income included in the taxpayer’s gross income from the judgment or settlement.

This “above-the-line” deduction helps to alleviate the tax burden for plaintiffs in qualifying cases by reducing their adjusted gross income. Without this provision, a taxpayer might be taxed on the full gross settlement amount, even the portion paid directly to their attorney, which can lead to a substantial tax liability on funds they never physically receive. Other deductions might apply, but the treatment of attorney fees is frequently the most impactful adjustment for individual taxpayers.

Reporting Settlement Income

Once the taxable and non-taxable components of a settlement are determined, the next step involves reporting the taxable income to the Internal Revenue Service (IRS). Payers of settlements often issue tax forms to recipients, Form 1099-MISC (Miscellaneous Information) or Form 1099-NEC (Nonemployee Compensation), if the taxable amount is $600 or more. Form 1099-MISC is commonly used for various types of settlement payments, including emotional distress damages not related to physical injury and punitive damages, which are reported as “other income.” Form 1099-NEC is issued if the settlement represents non-employee compensation for services, such as lost wages for an independent contractor.

If the settlement includes lost wages from employment, these amounts might be reported on a Form W-2, similar to regular wages. The forms received may reflect the gross settlement amount, and it is the taxpayer’s responsibility to correctly identify and report only the taxable portions on their tax return. For example, punitive damages are reported as “Other Income” on Schedule 1 (Form 1040), while lost wages may be reported as “Wages, salaries, tips, etc.” on Form 1040. If the settlement relates to a trade or business, lost profits would be reported on Schedule C (Form 1040).

Receiving a large taxable settlement often necessitates making estimated tax payments throughout the year. This is because income from settlements is not subject to withholding, unlike regular wages, which could result in an underpayment penalty if taxes are not paid as income is received. Taxpayers can make these quarterly estimated tax payments using Form 1040-ES. Taxpayers should maintain comprehensive records, including the settlement agreement, attorney invoices, and any documentation detailing the nature of the settlement. These records are important for substantiating the reported income and any deductions claimed.