Do You Get Taxed on a Lawsuit Settlement?
Understand how various factors determine the taxability of your lawsuit settlement, manage deductions, and fulfill reporting obligations.
A lawsuit settlement resolves a legal dispute with a financial payment. Its tax implications are complex, as the Internal Revenue Service (IRS) generally taxes all income unless specifically excluded. Taxability depends on the payment’s underlying reason, requiring detailed examination of its components.
Taxability Based on Settlement Type
Settlement tax treatment depends on the “origin of the claim,” or the nature of the injury.
Damages for personal physical injuries or sickness are excluded from gross income under Internal Revenue Code (IRC) Section 104. This covers medical expenses, pain and suffering, and lost wages directly from the injury. Settlements from car accidents or medical malpractice, involving bodily harm, are not taxable.
Emotional distress damages are taxable unless directly from a physical injury or sickness. If not linked to physical injury (e.g., defamation, discrimination), the settlement is taxable. Related medical expenses may be excludable if not previously deducted.
Settlements for lost wages, lost profits, or other lost income are taxable as ordinary income. This applies even if part of a personal injury settlement, as they replace income that would have been taxed. Payments are subject to federal income, Social Security, and Medicare taxes, like regular employment income.
Punitive damages, awarded to punish egregious conduct, are always taxable as ordinary income. This applies regardless of the underlying claim, even if it involves physical injury. Report these as “Other Income” on a tax return.
Settlements for property damage are not taxable up to the property’s adjusted basis. If the settlement exceeds this, the excess is a taxable capital gain. This recognizes a return of capital is not income, but any gain beyond the original investment is.
Other settlements have specific tax implications. Wrongful termination settlements are at least partially taxable, especially for lost wages or back pay. Breach of contract settlements are taxable, typically as ordinary income if replacing lost profits. Discrimination lawsuit settlements are taxable, unless for physical injuries or sickness.
Managing Deductions and Exclusions
Attorney fees from a settlement impact the net taxable amount, with specific deductibility rules. The full gross settlement, including attorney fees, may be taxable to the recipient, but exceptions exist. Generally, attorney fees are not deductible on federal income tax returns.
An “above-the-line” deduction for attorney fees and court costs is allowed in specific cases. This includes claims for unlawful discrimination, whistleblower awards, and civil rights, as outlined in IRC Section 62. This deduction prevents taxation on the portion paid directly to legal counsel.
If a settlement reimburses previously deducted medical expenses, that portion may become taxable. The “tax benefit rule” dictates that if a prior deduction reduced taxable income, its recovery must be included in income. Report this as “Other Income” on your tax return.
For property settlements, the portion representing a return of cost basis is not taxable income. This recovers the original investment. Only amounts exceeding this adjusted basis are taxable.
Reporting and Tax Payment Obligations
When a taxable settlement is received, the payer often has IRS reporting obligations. For certain payments, the payer may issue IRS Form 1099-MISC or Form 1099-NEC. Form 1099-NEC is for payments of $600 or more for non-employee services. Form 1099-MISC is for other income types, including prizes, awards, or other payments of $600 or more, or royalties of $10 or more.
For tax year 2025, the reporting threshold for both forms remains at $600. For tax year 2026, this threshold is set to increase to $2,000, with inflation adjustments in subsequent years.
Even if a Form 1099 is not issued, the income is taxable and must be reported. The absence of a form does not negate tax liability. This information assists taxpayers in accurate reporting and helps the IRS verify amounts.
A large taxable settlement can significantly increase income, potentially pushing taxpayers into a higher tax bracket or resulting in substantial tax liability. To avoid underpayment penalties, taxpayers with significant taxable income outside of regular wages should consider making estimated tax payments using Form 1040-ES, made quarterly.
Maintaining detailed settlement records is important for tax purposes. This includes copies of the settlement agreement, court orders, attorney invoices, and all correspondence. Documentation helps substantiate tax treatment and is essential if the IRS questions reported income.