Do Lawyers Pay Taxes on Settlement Money?

Settlement money refers to funds paid to resolve a legal dispute outside of court. These agreements arise from various claims, including personal injuries, employment disputes, or business disagreements. Lawyers often receive a portion of these funds as fees for their services, frequently through a contingent fee agreement. The tax implications of these fees for both the lawyer and client vary based on the settlement’s nature and applicable tax laws.

How Lawyers Report Their Share of Settlement Income

Lawyers treat the portion of settlement money they receive as professional fees. These fees are taxable income to the lawyer or firm, similar to other business revenue. The Internal Revenue Service (IRS) requires businesses, including law firms, to report payments of $600 or more for services on a Form 1099. This applies even if the law firm is structured as a corporation, LLC, or partnership.

Lawyers typically account for and report this income as gross receipts or revenue on their tax returns. For individual lawyers, these fees are subject to ordinary income tax rates, while law firms structured as corporations pay corporate tax. Lawyers can deduct various business expenses incurred in their practice against this income, such as office rent, staff salaries, and other operational costs. This allows them to determine their net taxable income.

How Attorney Fees Affect Your Settlement Taxation

Attorney fees impact the client’s tax liability related to a settlement. When a settlement is reached, a gross amount is determined, from which attorney fees and other legal costs are deducted. The Supreme Court case Commissioner v. Banks established that clients are taxed on the gross settlement amount, even if a portion goes directly to the attorney as fees. This means the client is considered to have received the full amount before legal fee deductions.

Historically, clients could deduct attorney fees as miscellaneous itemized deductions. However, the Tax Cuts and Jobs Act (TCJA) of 2017 suspended most miscellaneous itemized deductions for individuals from 2018 through 2025. This means that for many personal claims, clients cannot deduct legal fees, resulting in them paying tax on the entire gross recovery, including the portion paid to their attorney. This can lead to a higher effective tax burden for the client.

Specific exceptions exist where attorney fees reduce gross income for tax purposes, allowing an “above-the-line” deduction. These include certain whistleblower awards and claims involving unlawful discrimination, such as employment or civil rights cases. Legal fees for business matters are generally deductible as business expenses. These deductions reduce a taxpayer’s adjusted gross income (AGI).

Tax Treatment of Different Settlement Types

The taxability of settlement money for the client depends on the nature of the original claim. This is determined by the “origin of the claim” doctrine, which examines what the payment is intended to replace. If the settlement compensates for something that would have been taxable income, such as lost wages, the settlement portion is generally taxable.

Settlements for personal physical injuries or physical sickness are not included in federal gross income. This exclusion covers compensation for medical bills, pain and suffering, and lost wages directly related to the physical injury or sickness. However, the exclusion does not extend to all components of a settlement.

Compensation for emotional distress is taxable unless directly attributable to a physical injury or sickness. If emotional distress stems from observable physical harm, the compensation may be tax-free. Settlements for lost wages or lost profits not connected to a physical injury, such as from an employment dispute, are taxable as ordinary income.

Punitive damages, awarded to punish the wrongdoer rather than compensate for actual losses, are taxable as income. Any interest accrued on a settlement amount, from the time the claim arose until paid, is also taxable income. Taxpayers must report these taxable components on their federal income tax returns.