Do You Get Taxed on Legal Settlements?

The tax implications of legal settlements can be complex, with taxability often depending on the claim’s specific nature. Some settlement amounts are fully taxable, while others may be partially or entirely exempt from taxation. Understanding these distinctions is important for anyone receiving a legal settlement. The Internal Revenue Service (IRS) outlines specific rules governing the taxability of these funds, primarily based on what the settlement is intended to compensate.

Understanding Taxable Settlements

In the United States, all income is taxable unless specifically excluded by law. This rule, outlined in Internal Revenue Code Section 61, applies to legal settlements. If a settlement compensates for something ordinarily considered taxable income, the amount is generally subject to taxation. For instance, if a settlement includes payment for lost wages or business profits, these amounts are typically taxable because they replace income that would have been taxed. The “origin of the claim” doctrine determines a settlement’s taxability, meaning the reason the money was received dictates its tax treatment.

Non-Taxable Settlement Exclusions

Damages received for personal physical injuries or sickness are excluded from taxable income under Internal Revenue Code Section 104. This means settlements compensating for observable bodily harm, such as a broken bone or an illness, are generally not taxable. The exclusion also extends to compensatory damages for pain and suffering and emotional distress directly related to the physical injury or sickness. Medical expenses incurred due to physical injury or sickness are typically non-taxable; however, if previously deducted for a tax benefit, the reimbursed portion may become taxable under the tax benefit rule. It is important to distinguish physical injuries from emotional distress not stemming from a physical injury, as the latter generally does not qualify for tax-exempt status.

Tax Treatment of Specific Settlement Components

Several common components of legal settlements are generally taxable, even if the underlying claim involves physical injury. Lost wages or lost profits are almost always taxable as ordinary income, as these amounts replace income that would have been taxed through regular employment or business activities. Emotional distress damages are generally taxable unless the emotional distress is a direct result of a physical injury or sickness. For example, compensation for emotional distress from a defamation case without physical harm would typically be taxable.

Punitive damages, which are awarded to punish the wrongdoer, are always taxable as ordinary income, regardless of the underlying claim. Any interest awarded on a settlement, whether pre-judgment or post-judgment, is also typically taxable as ordinary income because interest is considered income generated from the use of money.

For settlements involving property damage, taxability depends on the property’s adjusted basis. If the settlement amount is less than or equal to the property’s adjusted basis, it is generally non-taxable, but the basis must be reduced by the settlement amount. If the settlement exceeds the adjusted basis, the excess amount may be taxable as a capital gain.

Reporting Requirements and Legal Fees

Recipients of legal settlements are generally responsible for reporting taxable income on their tax returns. Taxable settlement amounts are often reported to the IRS by the payer on Form 1099-MISC, “Miscellaneous Information.” If the settlement is employment-related and includes amounts considered wages, such as back pay, it may be reported on Form W-2. Even if a portion of a settlement is non-taxable, recipients might still receive a Form 1099-MISC, requiring them to report the total amount and then exclude the non-taxable portion.

The tax treatment of legal fees can be complex. Legal fees are generally considered part of the taxpayer’s gross income, even if paid directly to the attorney from the settlement. The Tax Cuts and Jobs Act of 2017 suspended most miscellaneous itemized deductions for individuals through 2025, which includes legal fees for many types of cases. Exceptions exist for certain claims, such as those related to unlawful discrimination or whistleblower awards, where legal fees may be deductible “above-the-line,” meaning they reduce gross income directly. Consulting a tax professional is advisable for specific guidance on deducting legal fees.