Do You Pay Taxes on Court Winnings?

Winning a court case or receiving a settlement can bring financial relief, but it often comes with a complex question: are these winnings taxable? The Internal Revenue Service (IRS) generally considers all income taxable unless specifically exempted by law. The taxability of court winnings depends heavily on the nature and origin of the award, rather than simply how the money was received. Understanding these distinctions is important to accurately manage potential tax obligations.

Understanding Taxable Court Winnings

Many types of court winnings and lawsuit settlements are considered taxable income by the IRS. Awards for lost wages or lost profits are typically taxable because they replace income that would have been taxed if earned in the normal course of business or employment. This includes back pay or unpaid wages from employment disputes, which are subject to both income and employment taxes.

Punitive damages, which are awarded to punish the at-fault party rather than compensate for a loss, are almost always taxable as ordinary income, regardless of the underlying claim. The IRS views these as a penalty against the defendant, not a reimbursement for damages. Additionally, any interest received on a judgment or settlement, whether pre-judgment or post-judgment interest, is also taxable. This applies even if the underlying award is non-taxable. Awards for damage to reputation or other non-physical injuries, such as those from breach of contract or fraud, are also usually taxable.

Identifying Non-Taxable Court Winnings

Certain types of court winnings are typically excluded from gross income and are not subject to federal income tax. The primary exemption applies to compensatory damages received on account of personal physical injuries or physical sickness. This exclusion under Internal Revenue Code Section 104 covers amounts received for medical expenses, pain and suffering, and even lost wages if they are a direct result of the physical injury or sickness.

For an award to be considered tax-free under this provision, the origin of the claim must be a physical injury or physical sickness. For example, a settlement from a car accident that covers hospital bills and pain and suffering is generally tax-free. Emotional distress damages are only non-taxable if they are directly attributable to a physical injury or physical sickness; if the emotional distress itself led to physical symptoms, the medical costs for those symptoms might be non-taxable, but the emotional distress compensation itself is generally taxable unless it stemmed from a physical injury. This distinction emphasizes that the physical nature of the injury is the determining factor for tax exclusion.

Reporting Your Court Winnings

When court winnings or lawsuit settlements include taxable components, the payer, such as the defendant or an insurance company, may issue specific IRS forms to report the income. For miscellaneous income, including many types of court winnings, Form 1099-MISC is commonly issued, with the taxable amount often appearing in Box 3, “Other Income.” If the award specifically represents lost wages from an employer, it might be reported on Form W-2, similar to regular employment income. Upon receiving a Form 1099-MISC, the amount reported in Box 3 is typically entered on Schedule 1 (Form 1040), Line 8, which is designated for “Other Income.”

If the settlement includes both taxable and non-taxable portions, only the taxable amounts should be reported as income. Even if a settlement is generally tax-free due to physical injury, the payer might still issue a Form 1099-MISC; in such cases, the taxpayer needs to account for this on their tax return, often by explaining the non-taxable nature of the funds. The IRS generally requires transparency regarding all forms of income or compensation, making accurate reporting crucial for tax compliance.

Considering Attorney Fees and Deductions

Attorney fees are a significant consideration when dealing with court winnings. The general rule is that if the award is taxable, the full amount of the award, before attorney fees are deducted, is considered gross income to the recipient. This means that a taxpayer might owe tax on money that was paid directly to their attorney.

For most individuals, attorney fees related to taxable judgments or settlements are generally not deductible as miscellaneous itemized deductions under current tax law, specifically due to the Tax Cuts and Jobs Act of 2017 suspending these deductions through 2025. However, limited exceptions exist for certain types of cases. Attorney fees and court costs related to whistleblowers or specific discrimination lawsuits (such as those for age, sex, or racial discrimination) may be deductible above-the-line, meaning they are subtracted from gross income to arrive at adjusted gross income (AGI). This deduction is typically reported on Schedule 1 (Form 1040), Line 24h, and cannot exceed the amount of the judgment or settlement included in income for the tax year.

Paying Taxes on Court Winnings

Court winnings, particularly large settlements or judgments, often do not have taxes withheld by the payer. This means that the recipient may be responsible for a substantial tax liability when filing their annual income tax return. The U.S. tax system operates on a “pay-as-you-go” basis, requiring taxpayers to pay income tax as they earn or receive income throughout the year. To avoid underpayment penalties, especially if the court winnings are substantial, individuals are generally advised to make estimated tax payments using IRS Form 1040-ES. These payments are typically due quarterly, with specific deadlines throughout the year:

April 15 for income earned January 1 to March 31
June 15 for income earned April 1 to May 31
September 15 for income earned June 1 to August 31
January 15 of the following year for income earned September 1 to December 31

If a due date falls on a weekend or holiday, the deadline shifts to the next business day.