Do You Pay Tax on Court Settlements?

The taxability of a court settlement depends on the reason for the payment. The Internal Revenue Service (IRS) uses an “origin of the claim” standard, which examines what the settlement money is intended to replace. If the funds replace income that would have been taxed, such as lost wages, that portion of the award is taxable. Conversely, money paid to compensate for non-taxable events, like a personal physical injury, is tax-free. The settlement agreement itself can be a guide, as it may allocate funds to different categories of damages.

Determining the Taxability of Your Settlement

According to Internal Revenue Code (IRC) Section 61, all income is considered taxable unless a specific exemption applies. For court settlements, the main exemption is found in IRC Section 104, which covers compensation for injuries and sickness. The details of your lawsuit and the specific damages awarded dictate whether you owe taxes on the money you receive.

Physical Injuries and Sickness

Compensation received for personal physical injuries or physical sickness is not taxable. This rule applies to payments for observable bodily harm, such as injuries from a car accident or a slip-and-fall incident. The entire amount meant to compensate for the physical injury, including any portion for lost wages resulting directly from that injury, is excluded from your gross income. This tax-free treatment applies whether the payment is a lump sum or made in periodic installments.

An exception involves medical expense deductions. If you previously deducted medical expenses related to the injury and later received a settlement for those same costs, you must report that portion of the settlement as income. This rule prevents a double tax benefit, and the amount you include is limited to the tax benefit you received from the original deduction.

Emotional Distress

The taxability of compensation for emotional distress depends on its cause. If the distress is a direct result of a physical injury or sickness, the funds are non-taxable. For example, compensation for anxiety stemming from a physical injury sustained in an accident is not included in income.

However, if the emotional distress does not originate from a physical injury, the settlement award is taxable. For instance, in a defamation or harassment lawsuit where there is no accompanying physical injury, any money awarded for the resulting emotional distress must be included in your gross income.

Lost Wages or Profits

Settlement money designated as a replacement for lost wages or business profits is taxable. The logic is that the original income would have been subject to tax, so the payment that replaces it should be taxed as well. This includes awards for back pay or front pay in employment-related lawsuits, such as those for wrongful termination or discrimination. These payments are considered wages and are subject to income tax withholding, Social Security, and Medicare taxes. If the settlement is for lost profits from a business, the income is subject to self-employment taxes.

Punitive Damages

Punitive damages are payments awarded to punish a defendant for their conduct, not to compensate a plaintiff for a specific loss. Under federal tax law, punitive damages are taxable. The tax code explicitly states that the exclusion for physical injury awards does not apply to punitive damages, meaning this rule applies even if the underlying lawsuit was for a non-taxable claim.

Interest

Interest may be paid on a settlement amount, especially if there is a delay between the agreement and the payment. Any interest you receive as part of a settlement is taxable as interest income. The payer will report this interest to you and the IRS on Form 1099-INT.

Property Damage or Loss

Settlements for property damage have a specific tax treatment. If the settlement amount is less than or equal to the adjusted basis of your property, the payment is not taxable. The adjusted basis is the original cost of the property plus improvements, minus depreciation. This payment is treated as a return of capital, and you must reduce your property’s basis by the settlement amount.

If the payment exceeds your adjusted basis, the excess is a taxable capital gain. For example, if your property’s adjusted basis is $15,000 and you receive a $20,000 settlement for its destruction, you have a $5,000 capital gain.

Deductibility of Legal Fees and Costs

The rules for deducting legal fees are narrow and were impacted by the Tax Cuts and Jobs Act of 2017 (TCJA), which suspended the deduction for most miscellaneous itemized deductions through 2025. This change disallows the deduction of legal fees for many personal cases where the recovery is taxable, including those involving defamation, malpractice, or false imprisonment. Separately, legal fees for personal physical injury cases are not deductible, as the IRS does not permit deducting expenses used to produce tax-exempt income.

An exception exists for legal fees paid in connection with specific types of lawsuits. If your case involves claims of “unlawful discrimination,” certain whistleblower actions, or specific claims against the federal government, you may be able to deduct your attorney’s fees. This is not an itemized deduction but an “above-the-line” deduction, which is more advantageous because it reduces your adjusted gross income (AGI).

This special deduction is claimed on Schedule 1 of Form 1040. Unlawful discrimination claims include those based on race, color, religion, sex (including sexual harassment), national origin, age, disability, and other protected characteristics under various laws. This provision ensures that individuals who receive taxable awards in these specific cases are not taxed on the portion of the settlement that goes directly to their attorneys.

How to Report Settlement Income

You must report all taxable portions of your settlement on your federal income tax return, even if you do not receive a tax form from the payer. Failing to report taxable settlement income can lead to penalties and interest. The payer may issue forms such as a Form 1099-MISC for punitive damages or taxable emotional distress awards, with the amount shown in Box 3, “Other income.”

The specific lines on your tax return where you report settlement income vary by category.

• Taxable lost wages are reported on Line 1a of Form 1040.
• Punitive damages and taxable emotional distress awards are reported as “Other Income” on Schedule 1 (Form 1040), Line 8z.
• Interest income is reported on Schedule B (Form 1040).
• A taxable capital gain from a property damage settlement is reported on Schedule D (Form 1040).