Do Settlements Count as Income for Tax Purposes?

Legal settlements are agreements reached outside of court to resolve disputes. When a settlement is received, its tax implications are a common concern. The Internal Revenue Service (IRS) generally considers most income taxable, including proceeds from legal settlements. However, significant exceptions exist. The taxability of a settlement depends on the specific nature of the claim and the purpose for which the damages were awarded.

Taxable Settlement Proceeds

Compensation for lost wages or profits is almost always taxable. This includes income replaced by a settlement, such as lost wages from employment discrimination or lost business profits. The IRS treats these amounts as if they were earned normally, making them subject to taxation.

Punitive damages, awarded to punish a wrongdoer, are always taxable. This applies regardless of the underlying claim, even if it involves a physical injury. These damages are viewed as additional income, not a reimbursement.

Emotional distress damages are taxable if they are not directly linked to a physical injury or sickness. For example, compensation for emotional distress from defamation or breach of contract without physical harm is taxable. Physical symptoms like headaches or insomnia are not considered physical injuries for tax purposes, making such compensation taxable.

Interest accrued on a settlement award is taxable income. This interest is treated similarly to interest earned on a savings account and is reported as such.

Attorney fees, especially contingency fees paid from the settlement, are considered income to the plaintiff. The gross settlement amount, including the attorney’s portion, is taxable to the plaintiff, even if paid directly to the attorney. The initial tax liability rests with the recipient of the full settlement.

Damages for breach of contract are taxable, as they often represent lost profits or other economic gains. If a contract dispute involves harm to a capital asset, recoveries are generally taxed as ordinary income. This also applies if the recovery compensates for the use of a capital asset.

Non-Taxable Settlement Proceeds

Compensation for personal physical injuries or sickness is not included in gross income. This includes amounts for medical expenses, pain and suffering, and lost wages directly attributable to the physical injury or sickness.

Emotional distress damages are non-taxable if directly caused by a physical injury or sickness. Establishing a direct link between the emotional distress and the physical injury is crucial. For example, compensation for anxiety arising directly from a car accident causing physical injuries is tax-free.

Compensation for property damage is non-taxable up to the property’s adjusted basis. This is because it is considered a return of capital, not new income. Any amount exceeding the adjusted basis is taxable.

Damages for loss of consortium or wrongful death are non-taxable. They are viewed as compensation for personal physical injury or sickness.

Reporting Settlement Income

Taxable settlement income requires reporting on specific tax forms. A Form 1099-MISC is often issued for taxable settlements. If lost wages are paid by an employer, a Form W-2 may be issued. These forms inform the IRS of the payment amount.

The allocation of damages within the settlement agreement is important for tax purposes. A clear agreement should specify portions for physical injuries, lost wages, punitive damages, or other categories. Without clear allocation, the IRS may presume the entire settlement is taxable.

Maintain thorough records of the settlement agreement, legal documents, and related communications. These records support the tax treatment claimed on a tax return. They are important for any tax authority inquiry.

Given the complexities of tax law, consulting a qualified tax professional, such as a CPA or tax attorney, is advised when receiving a settlement. Professionals can help determine taxability, ensure proper reporting, and explore deductions. This guidance helps avoid unexpected tax liabilities.