Do You Have to Pay Taxes on Court Settlements?

When a court settlement is received, its taxability depends on the nature of the claim and damages awarded. Some settlements are tax-free, while others are fully or partially taxable. Understanding these distinctions is important, as mischaracterizing income can lead to unexpected tax liabilities.

Identifying Taxable and Non-Taxable Components

Determining the taxability of a court settlement hinges on the “origin of the claim” doctrine. This principle means the tax treatment is based on the underlying claim that gave rise to the settlement, not the litigation’s consequences. The purpose for which the money was received is the key factor.

Damages received on account of physical injuries or physical sickness are excluded from gross income under Internal Revenue Code Section 104. Compensation for physical injuries or sickness, such as those from car accidents, slip and falls, or medical malpractice, is not taxable. Medical expenses reimbursed through a settlement are also non-taxable if they were not previously deducted.

However, the definition of “physical injury” is specific and does not include emotional distress unless directly attributable to a physical injury or physical sickness. Damages for emotional distress or mental anguish are taxable if they do not stem from a physical injury. For example, physical symptoms like headaches or insomnia resulting from emotional distress are not considered physical injuries for tax purposes.

Compensation for lost wages or lost profits is taxable as ordinary income. This includes back pay from employment disputes, as it replaces income that would have been taxable. These amounts are subject to regular income tax, and potentially Social Security and Medicare taxes.

Punitive damages are taxable, regardless of the nature of the underlying claim, even if received in a case involving physical injury. Intended to punish wrongdoers rather than compensate for loss, the IRS views these damages as income. There is a very limited exception for punitive damages awarded in certain wrongful death cases where state law only provides for punitive damages.

For property damage, the tax treatment depends on the amount received relative to the property’s adjusted basis. Damages for property damage are not taxable up to the adjusted basis of the property, as they are considered a return of capital. If the settlement amount exceeds the adjusted basis, the excess is treated as a taxable gain.

Any interest awarded on a settlement, whether pre-judgment or post-judgment, is taxable as ordinary income. This applies even if the underlying settlement amount is non-taxable, such as in a personal physical injury case. The IRS considers interest as compensation for the delay in receiving payment.

Reporting Requirements for Settlement Income

Recipients of taxable settlement income will receive specific tax forms from the payor. For taxable settlement income like emotional distress not linked to physical injury, lost wages, or punitive damages, a Form 1099-MISC, Miscellaneous Information, is issued. This form reports payments of $600 or more made in the course of a trade or business.

If a settlement includes back wages from an employer, these amounts may be reported on a Form W-2, Wage and Tax Statement, as they are considered wages subject to income and employment taxes. Any interest received as part of a settlement will be reported on a Form 1099-INT, Interest Income.

Taxable settlement income must be reported on the recipient’s federal income tax return. For most individuals, this involves reporting the income on Form 1040. For instance, punitive damages are reported as “Other Income” on Schedule 1 of Form 1040. Lost wages or back pay are reported on line 1 of Form 1040, similar to regular wages.

Some types of settlement income, particularly those characterized as wages, may be subject to tax withholding by the payor. However, for many other types of taxable settlement income, no tax is withheld, meaning the recipient may need to make estimated tax payments throughout the year to cover the tax liability. Failure to do so could result in penalties.

Tax Treatment of Legal Fees and Costs

The deductibility of legal fees incurred to obtain a court settlement has undergone significant changes. Under current tax law, due to the Tax Cuts and Jobs Act of 2017, most individual taxpayers can no longer deduct miscellaneous itemized deductions, including many types of legal fees. This suspension is in effect through 2025.

Despite the disallowance, there are specific circumstances where legal fees may still be deductible. Legal fees related to certain whistleblower awards and claims involving unlawful discrimination are deductible “above-the-line,” meaning they reduce adjusted gross income without requiring itemized deductions. This deduction is limited to the amount of the judgment or settlement included in income for the tax year.

Legal fees related to business income or income from rents and royalties may also be deductible as ordinary and necessary business expenses. For example, a business owner suing a client for non-payment could deduct the legal fees as a business expense. Similarly, legal fees incurred by a landlord for issues related to rental property can be deducted.

When a legal settlement involves a contingency fee arrangement, the entire settlement amount is considered the taxpayer’s gross income, even if a portion is paid directly to the attorney. This means the taxpayer is taxed on the full settlement amount before legal fees are deducted, unless an exception for above-the-line deductions applies.