Do Lawsuits Get Taxed? Non-Taxable vs Taxable Awards

When a lawsuit concludes, whether through a settlement or a court judgment, the financial proceeds received can sometimes be subject to federal income tax. Many individuals mistakenly believe that all money received from a lawsuit is tax-free. The actual tax treatment of these funds depends heavily on the nature and origin of the claim. Understanding the specific components of a settlement or judgment is important, as different types of damages have varying tax implications. Careful consideration ensures proper reporting to tax authorities.

Understanding Taxable and Non-Taxable Lawsuit Proceeds

The taxability of lawsuit proceeds hinges on the “origin of the claim” doctrine, which examines the basic reason the lawsuit was filed. If the lawsuit’s underlying purpose was to recover for a physical injury or physical sickness, the damages received are excluded from gross income. This exclusion covers compensation for medical expenses, pain and suffering, emotional distress directly linked to the physical injury, and lost wages if the claim’s origin is solely a physical injury or sickness. For instance, if a person sustains a broken leg in an accident and receives compensation for medical bills and the inability to work during recovery, both components are not taxable under Internal Revenue Code Section 104.

Many types of lawsuit proceeds are considered taxable income. Awards for lost wages or lost profits, even if they arise from a case involving physical injury, are subject to taxation. For example, if a settlement includes specific amounts for income an individual would have earned had they not been injured, that portion is taxable. Similarly, damages received for emotional distress are taxable unless the emotional distress is directly attributed to a physical injury or physical sickness. This means emotional distress arising from defamation or employment discrimination, without a direct physical manifestation, would be taxable.

Punitive damages, which are awarded to punish a defendant for egregious conduct rather than to compensate the plaintiff, are always included in gross income and are taxable. This rule applies regardless of the underlying nature of the claim, even if the primary award was for physical injury. For example, a settlement for a physical injury that also includes a separate amount identified as punitive damages will have the punitive portion taxed. Interest awarded on a judgment or settlement is also taxable, as it represents compensation for the delay in receiving funds rather than for the injury itself.

Other types of damages that are taxable include those for breach of contract, defamation, or discrimination claims not involving a physical injury. For instance, if a lawsuit resolves a dispute over a business agreement and results in a payment for lost profits, that payment is taxable income. Property damage awards can also result in taxable income if the amount received exceeds the adjusted basis of the damaged property. If a building with an adjusted basis of $100,000 is damaged and a $150,000 settlement is received, the $50,000 gain would be taxable.

Reporting Lawsuit Proceeds to the IRS

After determining which portions of lawsuit proceeds are taxable, the next step involves reporting these amounts to the Internal Revenue Service (IRS). Recipients of taxable lawsuit proceeds may receive various tax forms depending on the nature of the payment. For instance, if the settlement includes lost wages paid by an employer, the amount might be reported on Form W-2, Wage and Tax Statement. Payments for other types of taxable income, such as certain emotional distress damages, punitive damages, or breach of contract awards, are commonly reported on Form 1099-MISC, Miscellaneous Information, in Box 3, “Other Income.”

Interest income received on a judgment or settlement is reported on Form 1099-INT, Interest Income. The payer of the settlement or judgment is responsible for issuing these forms to the recipient and to the IRS. Individuals should retain copies of all settlement agreements, court orders, and related legal documents. These records provide documentation for the amounts received and their classification, which can be important if the IRS has questions.

Taxable lawsuit proceeds are reported on different lines of the federal income tax return, Form 1040, depending on their character. Taxable lost wages, if reported on Form W-2, would be included on Line 1 of Form 1040. Other taxable settlement income reported on Form 1099-MISC, such as punitive damages or emotional distress not from physical injury, is reported on Schedule 1 (Form 1040), Additional Income and Adjustments to Income, under “Other Income.” Interest income reported on Form 1099-INT is reported on Schedule B (Form 1040), Interest and Ordinary Dividends.

Deducting Legal Fees and Related Costs

The ability to deduct legal fees and other litigation costs has changed for most individual taxpayers in recent years. Under the Tax Cuts and Jobs Act (TCJA) of 2017, miscellaneous itemized deductions that were previously subject to the 2% adjusted gross income (AGI) limitation were suspended for tax years 2018 through 2025. This change means that for many types of lawsuits, such as those involving employment discrimination, defamation, or breach of contract, legal fees paid by individuals are no longer deductible. Consequently, a taxpayer might receive a gross settlement amount and be taxed on that full amount, even if a significant portion goes directly to their attorney.

However, specific exceptions allow for the deduction of legal fees in certain circumstances. Legal fees related to whistleblower awards, where the individual provides information to the government resulting in the recovery of funds, can still be deducted. These fees are deductible “above-the-line,” meaning they reduce a taxpayer’s adjusted gross income (AGI). This type of deduction is reported on Schedule 1 (Form 1040).

Additionally, legal fees incurred in connection with certain civil rights cases or claims of unlawful discrimination can also be deducted above-the-line. These deductions help alleviate the tax burden on individuals who receive taxable awards in these specific types of cases. For example, if a settlement for an unlawful discrimination claim includes taxable back pay, the legal fees associated with obtaining that award can reduce the individual’s taxable income. Legal fees related to income from a business or property held for the production of rents or royalties are deductible on Schedule C (Form 1040), Profit or Loss from Business, or Schedule E (Form 1040), Supplemental Income and Loss, respectively.

Special Situations and Considerations

Structured settlements represent a unique approach to resolving personal injury lawsuits, providing payments over time rather than a single lump sum. When structured settlements arise from physical injury or physical sickness claims, the periodic payments received by the claimant are excluded from gross income. This arrangement offers tax advantages by spreading out tax-free income over many years, providing financial security. However, if a structured settlement includes components that would ordinarily be taxable, such as punitive damages, those specific portions remain taxable as they are received.

A common scenario involves attorney fees being paid directly from the gross settlement amount. The IRS views the entire gross settlement amount as the taxpayer’s income, even if a portion is immediately paid to the attorney. This concept is often referred to as the “assignment of income” doctrine. For example, if a $100,000 taxable settlement is reached and $30,000 goes directly to the attorney, the taxpayer is considered to have received the full $100,000 for tax purposes, subject to the limited deductibility of legal fees previously discussed.

The allocation of damages within a settlement agreement is an important consideration for tax purposes. When a lawsuit involves multiple types of claims, some taxable and some non-taxable, the settlement agreement should clearly specify how the total amount is allocated among these different claims. For instance, an agreement might explicitly allocate a portion to physical injury damages (non-taxable) and another portion to lost wages or emotional distress not related to physical injury (taxable). Without a clear allocation, the IRS may determine the allocation, potentially in a manner unfavorable to the taxpayer. Seeking legal and tax counsel during settlement negotiations is prudent to ensure the allocation is reasonable and supports the intended tax treatment.