Do You Get Taxed on Lawsuit Settlements? A Simple Answer

Understanding the tax implications of lawsuit settlements can be complex. The Internal Revenue Service (IRS) generally considers all income taxable unless specifically exempted by law. Whether a settlement is taxed depends entirely on the nature of the damages it is intended to replace. Different types of compensation within a settlement are viewed distinctly for tax purposes, leading to varied tax outcomes for recipients.

The IRS examines the “origin of the claim” to determine how settlement proceeds should be taxed. This involves looking at the underlying reason for the lawsuit and what the payment is meant to compensate. For instance, a settlement for medical bills might be treated differently than one for lost wages or emotional distress. The specific language in a settlement agreement can also influence how the IRS classifies the payments for tax purposes.

Determining Taxability of Damages

Internal Revenue Code Section 104 generally excludes from gross income damages received on account of “personal physical injuries or physical sickness.” This means that if the settlement compensates you for observable bodily harm, such as bruising, swelling, or bleeding, it is typically not taxable. Physical injury refers to observable bodily harm, while physical sickness denotes an illness.

For example, compensation for medical bills, pain and suffering, and lost wages directly related to a physical injury or sickness are generally tax-free. If you received compensation for medical expenses and did not itemize and deduct those expenses in previous tax years, the full amount is non-taxable. However, if you did deduct medical expenses in prior years, you must include the portion of the settlement that reimbursed those expenses as income to the extent the deduction provided a tax benefit.

Damages for lost wages or lost profits are generally taxable as ordinary income. These payments are considered a replacement for income that would have been taxable if earned normally. For instance, if a settlement includes compensation for back pay or unpaid wages, the IRS treats it as taxable income, subject to income tax and potentially Social Security and Medicare taxes.

Emotional distress damages are taxable unless the emotional distress directly resulted from a physical injury or physical sickness. If the emotional distress is not connected to a physical injury, such as distress from workplace harassment without physical harm, the compensation is generally taxable. The IRS distinguishes between emotional distress symptoms and objective signs of a physical condition when determining taxability.

Punitive damages are almost always taxable, regardless of whether the underlying claim involved a physical injury or sickness. These damages are awarded to punish the at-fault party rather than to compensate for actual losses, and they are reported as “Other Income” on Schedule 1 of Form 1040. Even if the primary settlement for physical injury is tax-free, any punitive damages included will be subject to taxation.

Any interest awarded on a settlement is also taxable as ordinary income. This includes both pre-judgment and post-judgment interest, which must be reported as interest income. Even if the core settlement amount is not taxable, the interest component will be.

Regarding attorney fees and court costs, if a settlement amount is includable in income, the attorney’s fees are also generally included in the taxpayer’s gross income, even if paid directly to the defendant. The American Jobs Creation Act of 2004 allows an above-the-line deduction for attorney fees and court costs in certain cases, such as those involving unlawful discrimination or whistleblower claims. This means these fees are deductible from gross income before calculating adjusted gross income, which can reduce the overall tax liability for qualifying settlements.

Specific Settlement Types and Their Tax Implications

The taxability rules apply differently depending on the nature of the lawsuit and the damages awarded. Understanding these applications helps clarify how various settlements are treated for tax purposes.

Personal Injury Settlements

Personal injury settlements, such as those from car accidents or medical malpractice, are generally not taxable if the compensation is for physical injuries or physical sickness. For instance, money received for medical bills, pain and suffering, or lost wages directly resulting from a physical injury is typically excluded from income. However, if the settlement includes punitive damages, that portion remains taxable, as punitive damages are always considered income.

Wrongful Termination or Employment Discrimination Settlements

Wrongful termination or employment discrimination settlements often involve multiple types of damages. Lost wages, which replace income that would have been earned, are fully taxable as ordinary income and are subject to employment taxes. Emotional distress damages in these cases are generally taxable unless the emotional distress arose from a direct physical injury or sickness. For example, if the discrimination led to a physical illness requiring medical treatment, the portion of the settlement related to that physical illness might be non-taxable, but the general emotional distress component would typically be taxed.

Property Damage Settlements

Property damage settlements are generally non-taxable up to the adjusted basis of the damaged property. This means if the compensation received is equal to or less than the property’s original cost minus any depreciation, it is usually not taxable. However, if the settlement amount exceeds the adjusted basis, the excess amount may be taxable as a capital gain. Additionally, if a property damage settlement includes compensation for lost income, such as lost rental income from a damaged property, that portion would be taxable as ordinary income.

Defamation Settlements

Defamation settlements typically involve damages for harm to reputation and emotional distress. Since defamation generally does not involve a physical injury, damages for reputational harm and emotional distress are usually taxable. The IRS considers these amounts as ordinary income unless the emotional distress can be directly attributed to a physical injury caused by the defamation, which is a rare occurrence. Any interest awarded on a defamation settlement would also be taxable.

Reporting Lawsuit Settlements

Taxable lawsuit settlement income must be properly reported to the IRS. The payer of the settlement is generally responsible for issuing specific tax forms to the recipient.

For many types of taxable settlements, the payer will issue Form 1099-MISC, Miscellaneous Information, or Form 1099-NEC, Nonemployee Compensation. In situations where a settlement includes lost wages from an employer, a Form W-2, Wage and Tax Statement, may be issued. This form reports wages, salaries, and other compensation, and the lost wages portion of a settlement is treated similarly to regular earnings for tax purposes. It is important to note that even if you do not receive a specific tax form, you are still responsible for reporting all taxable income from a lawsuit settlement on your tax return.

Maintaining detailed records related to the settlement agreement is important. This includes documentation that clearly allocates the settlement funds to different types of damages, such as physical injury, emotional distress, or lost wages. Such documentation helps in accurately determining the taxable and non-taxable portions of the settlement when preparing your tax return. You may need to make estimated tax payments if you expect your tax liability from a settlement to be $1,000 or more after accounting for credits and withholding.