Do I Pay Taxes on a Settlement? What You Need to Know

Many people are surprised to learn that settlement proceeds may be subject to taxation. The tax treatment of settlement funds depends on what the settlement is intended to compensate.

Understanding Settlement Taxability

The taxability of settlement proceeds is determined by the “origin of the claim” doctrine. This IRS principle dictates that the tax character of the settlement income is based on the nature of the claim. For instance, if a settlement compensates for lost wages, it is generally taxed as wages, because the original wages would have been taxable.

Damages for personal physical injuries or physical sickness are generally excluded from gross income under Internal Revenue Code Section 104(a)(2). This exclusion does not typically extend to damages for non-physical injuries, such as emotional distress not directly linked to a physical injury, or to punitive damages. These other types of damages are generally considered taxable income.

Tax Treatment of Common Settlement Types

Personal Physical Injuries or Sickness

Settlements for personal physical injuries or physical sickness are generally excluded from taxable income. This exclusion applies to compensation for medical expenses, pain and suffering, and other damages directly resulting from the physical injury or illness. Emotional distress damages are non-taxable only if directly attributable to a physical injury or sickness.

For example, if a settlement includes compensation for medical bills and lost income due to a physical injury, the portion related to the physical injury and associated emotional distress is typically not taxed. However, any portion received for emotional distress not directly linked to a physical injury or sickness is generally taxable.

Emotional Distress (Not from Physical Injury)

Settlements for emotional distress not stemming from a personal physical injury or sickness are typically taxable. This includes damages for emotional distress caused by non-physical harm, such as defamation or discrimination.

If medical expenses are incurred for the treatment of emotional distress and were not previously deducted, the portion of the settlement compensating for these specific medical expenses may be excludable from income. Otherwise, emotional distress damages remain taxable unless directly linked to a physical injury.

Lost Wages or Profits

Compensation for lost wages, lost profits, or loss of income as part of a settlement is generally taxable. These amounts are considered a substitute for income that would have been taxable if earned normally, and the IRS treats them as ordinary income. The payer may report these amounts on IRS Form 1099-NEC, Nonemployee Compensation, or Form 1099-MISC, Miscellaneous Information.

Punitive Damages

Punitive damages are almost always taxable, regardless of the underlying claim or whether they relate to a physical injury or sickness. These damages are awarded to punish the wrongdoer and deter similar conduct, not to compensate for actual losses. Even if a settlement for a physical injury is largely tax-free, any portion designated as punitive damages will be included in the recipient’s gross income.

Property Damages

The taxability of settlements for property damages depends on whether the amount received exceeds the property’s adjusted basis. If the settlement is less than or equal to the adjusted basis, it generally reduces the basis and is not taxable. The adjusted basis is typically the original cost plus improvements, minus depreciation.

If the settlement exceeds the adjusted basis, the excess is considered a taxable gain. For example, if a property with an adjusted basis of $50,000 is damaged and the settlement is $60,000, then $10,000 would be a taxable gain. This gain is typically treated as a capital gain if the property was a capital asset.

Defamation Settlements

The tax treatment of defamation settlements depends on whether the defamation caused personal physical injuries or sickness. If the defamation directly resulted in a physical injury or sickness, the portion of the settlement attributable to those physical injuries may be excludable from income. For instance, if defamation led to a stress-induced heart attack, damages for the heart attack itself might be non-taxable.

However, if the defamation did not cause any physical injury, the settlement proceeds are generally taxable. This includes damages for harm to reputation, emotional distress not linked to physical injury, or lost income resulting from the defamation.

Attorney Fees

Attorney fees paid out of a taxable settlement are generally deductible as an itemized deduction, subject to limitations. For contingent fees, the full settlement amount is generally included in the taxpayer’s gross income, even the portion paid directly to the attorney. The taxpayer can then deduct the attorney fees.

For certain claims, such as unlawful discrimination or whistleblower claims, attorney fees may be deductible as an above-the-line deduction, reducing adjusted gross income without requiring itemization. However, for most other taxable settlements, the deduction for attorney fees is a miscellaneous itemized deduction, which is currently not allowed for tax years through 2025. This means attorney fees associated with a taxable settlement might not be deductible, leading to higher taxable income.

Reporting Settlement Proceeds

When you receive a taxable settlement, the payer may issue IRS Form 1099-MISC, Miscellaneous Information, or Form 1099-NEC, Nonemployee Compensation, to report the income. Form 1099-MISC is typically used for amounts of $600 or more paid as “Other Income.” Form 1099-NEC is used for nonemployee compensation, such as lost wages if you were an independent contractor.

The absence of a Form 1099 does not mean settlement income is not taxable; you are still obligated to report all taxable income, regardless of whether you receive a reporting form. Taxable settlement income should be reported on your federal income tax return, often on Schedule 1 (Form 1040) as “Other Income.”

Maintain thorough documentation, including the settlement agreement, court orders, and expense records. These documents can help substantiate non-taxable portions and support deductions. Consulting a tax professional is advisable for proper reporting and compliance.