Do You Pay Taxes on a Lawsuit Settlement?

The Internal Revenue Service (IRS) generally considers most income taxable unless a specific exclusion is provided by law. This principle applies to funds received from legal settlements or awards. Recipients must determine which portions, if any, are subject to taxation, as the tax treatment depends on the specific nature of the damages awarded.

Determining Taxability of Damages

The taxability of damages from a lawsuit settlement depends on the “origin of the claim,” or what the settlement was intended to replace. Damages for personal physical injuries or physical sickness are generally excluded from gross income under Internal Revenue Code Section 104. This exclusion applies to compensatory damages for medical expenses, pain and suffering, and lost wages directly related to the physical injury or sickness. For the exclusion to apply, the injury must be physical and observable, such as bruising, swelling, or bleeding.

Damages for emotional distress are taxable unless the emotional distress originated from a physical injury or physical sickness. If emotional distress leads to physical symptoms like headaches or stomach disorders, these symptoms are considered manifestations of emotional distress, not physical injury, and thus remain taxable. Lost wages or profits are also taxable because they replace income that would have been subject to tax if earned through regular employment or business operations.

Punitive damages, awarded to punish the defendant rather than compensate for a loss, are always taxable. This applies regardless of the underlying claim, even if primary damages were for physical injuries or sickness. Any interest awarded on a settlement is also taxable income. Damages for defamation or reputational harm are generally taxable unless directly linked to a physical injury or sickness.

Reporting Settlement Income

When you receive a taxable lawsuit settlement, the payer may issue a tax form to report the income. Form 1099-MISC is commonly used for various types of miscellaneous income, including certain settlement payments. If the settlement represents nonemployee compensation, such as for services rendered, Form 1099-NEC may be issued instead. These forms are sent to both the recipient and the IRS, making accurate reporting on your tax return important.

The specific form and box where income is reported depend on the settlement’s nature. Taxable emotional distress or punitive damages might be reported in Box 3 (“Other Income”) of Form 1099-MISC. If the settlement includes lost wages, the taxable portion may be reported as wages on Form W-2, or on a Form 1099 if you were an independent contractor. You generally report taxable settlement income on Schedule 1 of Form 1040, though specific lines vary based on the income type.

Deducting Legal Expenses

Attorney fees and other legal expenses incurred to obtain a lawsuit settlement can have tax implications. Generally, attorney fees are paid from the gross settlement amount, meaning the full settlement amount, before fees, is often considered income to the recipient. However, specific rules allow for the deduction of these expenses in certain situations.

Under Internal Revenue Code Section 62, an above-the-line deduction is permitted for attorney fees and court costs paid in connection with certain lawsuits. This includes claims involving unlawful discrimination, civil rights cases, and whistleblower awards. An “above-the-line” deduction reduces your gross income to arrive at your adjusted gross income (AGI), which can be advantageous. For most other cases, the deductibility of legal expenses for individuals is limited. Due to the Tax Cuts and Jobs Act of 2017, miscellaneous itemized deductions are suspended through 2025. This suspension often means individuals cannot deduct attorney fees for taxable settlements not falling under specified exceptions, leading to taxation on the full settlement amount.

Importance of Settlement Allocation

The language within a settlement agreement is important in determining the tax treatment of received funds. The tax implications of a settlement are dictated by the “nature of the claim” and how damages are specifically allocated within the agreement. A clear and detailed allocation helps define which portions of the settlement are taxable and which are not. Explicitly stating amounts for physical injury versus emotional distress or lost wages can significantly impact the tax burden.

Without a precise allocation in the settlement agreement, the IRS may determine the allocation, potentially leading to a higher taxable amount than anticipated. This can result in a less favorable tax outcome for the recipient. Therefore, it is advisable to carefully review and negotiate the terms of a settlement agreement before signing, ensuring the allocation of damages accurately reflects the claims and minimizes potential tax liabilities.