Do You Claim Settlement Money on Taxes?

Settlement money, received to resolve a legal dispute or claim, can have varying tax implications. Understanding the tax treatment of these funds is important for individuals to manage finances and comply with tax regulations.

Determining Taxable Settlement Income

The taxability of settlement income hinges on the “origin of the claim” doctrine, which examines the nature of the underlying claim that led to the settlement. Generally, all income is taxable unless a specific exclusion applies under the Internal Revenue Code (IRC).

Settlements for physical injuries or physical sickness are excluded from gross income and are not taxable. This exclusion applies to compensatory damages, including medical expenses, pain and suffering, and lost wages directly resulting from the physical injury or sickness. If medical expenses related to the physical injury were previously deducted, any reimbursement for those specific expenses may be taxable under the tax benefit rule.

Emotional distress settlements are non-taxable only if directly related to a personal physical injury or physical sickness. If the emotional distress did not arise from a physical injury or sickness, the settlement funds are taxable. However, the taxable amount may be reduced by any medical expenses paid for the emotional distress that were not previously deducted.

Most other types of settlement income are considered taxable. Lost wages or profits, such as those from employment disputes or breach of contract cases, are taxable because they replace income that would have been taxed if earned normally. These amounts are subject to income tax, and in some cases, employment taxes like Social Security and Medicare.

Punitive damages, awarded to punish the wrongdoer rather than compensate for actual losses, are taxable as ordinary income, regardless of the underlying claim. This applies even if they are part of a settlement for physical injuries. Any interest received on settlement awards, whether pre-judgment or post-judgment, is taxable as interest income.

Settlements for damage to reputation or character are taxable unless directly related to a physical injury. For property damage settlements, the funds are not taxable if they are less than or equal to the adjusted basis of the property. However, if the settlement amount exceeds the property’s adjusted basis, the excess is taxable income.

Attorney fees present a specific consideration. Attorney fees are considered part of the gross income received by the plaintiff, even if paid directly to the attorney by the defendant. The Tax Cuts and Jobs Act of 2017 eliminated miscellaneous itemized deductions, including those for attorney fees, for tax years 2018 through 2025.

Structured settlements involve periodic payments over time rather than a lump sum. The tax treatment of these payments mirrors the tax treatment of the underlying damages for which they were awarded. For personal physical injury or wrongful death cases, structured settlement payments are tax-free, including any investment earnings, under IRC Section 104. However, if the underlying settlement is taxable, such as for lost wages or punitive damages, the structured payments will be taxable as ordinary income when received.

Reporting Settlement Proceeds

Once the taxable and non-taxable portions of a settlement have been determined, the next step involves properly reporting these amounts to the Internal Revenue Service (IRS). The payer of the settlement may issue various tax forms to report the funds provided.

Common forms include Form 1099-MISC, issued for miscellaneous income, including taxable settlements of $600 or more, such as lost wages or punitive damages. For lost wages from employment disputes, a Form W-2 is issued, treating the settlement as regular wages subject to employment tax withholding. Form 1099-NEC (Nonemployee Compensation) is also used for nonemployee compensation.

Taxable settlement income must be reported on an individual’s Form 1040. The specific line item depends on the nature of the income. Lost wages, reported on a Form W-2, are entered on line 1a of Form 1040. Other taxable income, such as punitive damages or emotional distress not linked to physical injury, is reported on Schedule 1 (Form 1040), line 8z, as “Other Income”. If the settlement includes lost business profits, these amounts are reported on Schedule C (Form 1040) as business income and may be subject to self-employment tax.

Even though settlements for physical injuries or sickness are non-taxable, it is advisable to report them to the IRS, especially if a Form 1099-MISC was issued for the full amount. This can be done by reporting the total amount on Form 1040, line 8i, and designating it as “NTS” (non-taxable settlement) to avoid IRS inquiries about unreported income.

Receiving a large taxable settlement necessitates paying estimated taxes throughout the year to avoid underpayment penalties. Individuals can use Form 1040-ES, Estimated Tax for Individuals, to calculate and pay these estimated taxes. This ensures compliance and prevents unexpected penalties.