Do You Pay Tax on Court Settlements?

The Internal Revenue Service (IRS) generally considers all income taxable unless specifically excluded by law. This principle extends to court settlement proceeds, meaning some or all of a settlement might be subject to federal income tax. The tax treatment hinges on the nature of the claim and the specific damages for which the settlement is paid.

Understanding Taxability Factors

The taxability of court settlement proceeds largely depends on the “origin of the claim.” Internal Revenue Code Section 104 provides specific exclusions for certain types of damages. If a settlement covers multiple types of damages, the tax treatment applies to each component separately.

Physical Injury or Sickness

Damages received on account of personal physical injuries or physical sickness are generally excluded from gross income under Internal Revenue Code Section 104. Examples include compensation for medical expenses, lost wages directly related to the physical injury, and pain and suffering stemming from the physical harm. If, however, medical expenses related to the injury were previously deducted on a tax return, and that deduction provided a tax benefit, the portion of the settlement covering those previously deducted expenses might be taxable.

Emotional Distress

Damages for emotional distress or mental anguish are generally taxable unless they are directly attributable to a physical injury or physical sickness. For instance, if emotional distress arises from a physical injury, the compensation for that emotional distress is typically not taxable. However, if the lawsuit is based purely on mental or emotional distress without an underlying physical injury, any settlement received for that distress is usually taxable.

Punitive Damages

Punitive damages are almost always taxable, regardless of the underlying claim or whether they relate to a physical injury or sickness. These damages are intended to punish the wrongdoer, not to compensate the injured party, and are therefore included in gross income.

Lost Wages/Income

Compensation for lost wages or lost profits is generally taxable as ordinary income. This includes back pay from employment discrimination cases or lost business profits. If the settlement includes an amount for lost wages, that portion is typically treated as taxable income, similar to regular earnings.

Interest on Awards

Any interest received on a settlement or judgment is generally taxable. This interest is considered ordinary income, even if the underlying settlement proceeds are not taxable. The interest accrues from the time the claim arose until the payment is received.

Attorney Fees

Attorney fees paid directly from a taxable settlement are generally considered taxable income to the recipient, even if the attorney receives the funds directly. This is due to the “assignment of income” doctrine, which states that income is taxed to the person who earned it.

There are specific exceptions for deducting attorney fees. Internal Revenue Code Section 62 allows an “above-the-line” deduction for attorney fees and court costs paid in connection with certain types of claims. This deduction applies to actions involving unlawful discrimination claims or whistleblower claims. An above-the-line deduction reduces adjusted gross income, which can be more advantageous than a miscellaneous itemized deduction.

Reporting Your Settlement Income

When you receive a court settlement, the payer typically issues tax forms to report the income to both you and the IRS.

Forms Received

You might receive different tax forms depending on the nature of your settlement. If the settlement includes lost wages or back pay from an employer, you may receive a Form W-2, Wage and Tax Statement. This form reports the income as wages, subject to payroll taxes. For other types of taxable settlement payments, such as punitive damages, emotional distress (not tied to physical injury), or post-judgment interest, you will likely receive a Form 1099-MISC, Miscellaneous Information, or Form 1099-NEC, Nonemployee Compensation.

Form 1099-MISC reports “other income.” Form 1099-NEC is specifically for nonemployee compensation and indicates that self-employment taxes may be due in addition to income taxes. If your settlement includes non-wage payments from a wrongful termination or emotional distress claim, you generally want that portion reported on Form 1099-MISC to avoid self-employment tax.

IRS Reporting

Taxable settlement income is reported on your Form 1040, U.S. Individual Income Tax Return. Wage portions reported on a Form W-2 are entered on Line 1 of Form 1040. Other types of taxable settlement income, such as punitive damages, emotional distress (not related to physical injury), and interest, are generally reported on Schedule 1 (Form 1040), Additional Income and Adjustments to Income. These amounts are often reported on Line 8, “Other income,” of Schedule 1. It is important to attach a statement detailing the nature of the settlement proceeds.

Documentation

Maintaining thorough records related to your settlement agreement and payments is important. The settlement agreement should clearly allocate the funds among various claims, such as medical expenses, lost wages, or emotional distress. This allocation directly influences the tax treatment of each portion and provides crucial documentation for your tax return. Keeping copies of all tax forms received, such as Forms 1099-MISC, 1099-NEC, or W-2, along with the settlement agreement, is advisable for future reference or in case of an IRS inquiry.

Managing Tax Obligations

Receiving a taxable settlement can significantly increase your income in a given year, potentially leading to a higher tax liability. It is important to plan for these tax obligations to avoid penalties.

Estimated Taxes

If you receive a large taxable settlement, you may be required to pay estimated taxes using Form 1040-ES, Estimated Tax for Individuals. Estimated taxes are required for income not subject to withholding, such as self-employment earnings, interest, dividends, or large settlement payments. Generally, you must pay estimated tax if you expect to owe at least $1,000 in tax for the year, after subtracting your withholding and refundable credits.

Estimated tax payments are typically made in four equal installments throughout the year, with due dates in April, June, September, and January of the following year. Failing to pay enough estimated tax, or not paying on time, can result in penalties for underpayment. You can use the Form 1040-ES worksheet or tax software to calculate your estimated tax liability.

Withholding

In some cases, the payor of a settlement might withhold taxes directly from the payment. This is common if the settlement includes lost wages paid by an employer, which are subject to typical payroll withholding. For other taxable settlement components, withholding is less common, placing the responsibility on the recipient to manage their estimated tax payments. It is advisable to clarify any potential withholding with the payor or their legal counsel during the settlement process.

Structured Settlements

A structured settlement involves receiving payments over a period of time, rather than as a single lump sum. This approach can spread out the tax liability for taxable settlements, potentially keeping the recipient in a lower marginal tax bracket each year. For settlements arising from personal physical injury or sickness, structured settlement payments are completely tax-exempt under Internal Revenue Code Section 104, including any interest earned on the annuity that funds the payments.

However, if a structured settlement arises from a non-physical injury case, such as an employment dispute or breach of contract, the payments are generally taxable as ordinary income when received. While a structured settlement does not make otherwise taxable income tax-exempt, it can defer the recognition of income, which can be a valuable tax management strategy.