Do You Pay Taxes on Lawsuit Settlements?

Receiving a lawsuit settlement can provide financial relief, but it often brings questions about tax obligations. The Internal Revenue Service (IRS) generally considers settlement money taxable income unless a specific exclusion applies. Understanding these nuances helps avoid unexpected tax liabilities.

Understanding Taxability of Lawsuit Settlements

The IRS generally considers all income taxable unless specifically exempted by law. Lawsuit settlements typically fall under this broad definition, though specific exclusions exist. The taxability of a settlement depends on the nature of the claim that led to the payment.

Damages for personal physical injuries or physical sickness are generally excluded from gross income. This means settlements for injuries like those from car accidents, slip and falls, or medical malpractice are typically not taxed if they compensate for observable bodily harm. This exclusion applies to amounts covering medical expenses, pain and suffering, and lost wages directly related to the physical injury or sickness. If medical expenses were previously deducted, any portion of the settlement compensating for those expenses must be included in income up to the amount of the prior deduction.

Damages for emotional distress are generally taxable unless directly linked to a personal physical injury or sickness. If emotional distress leads to physical symptoms, these damages might be excludable, but clear documentation linking the distress to a physical cause is often necessary. If the emotional distress is not tied to a physical injury, the compensation is usually considered taxable income. This distinction highlights how damages are characterized in a settlement agreement.

Compensation for lost wages, lost profits, or other income is generally taxable. These amounts replace income that would have been taxable had it been earned in the normal course of business or employment. For instance, a settlement for wrongful termination that includes back pay is treated as taxable wages. Lost profits from a business dispute are also typically subject to tax.

Punitive damages are almost always taxable, regardless of the nature of the underlying claim, even if the lawsuit involves physical injuries. The IRS views punitive damages as a penalty against the defendant rather than compensation for a loss, making them ordinary income to the recipient. A limited exception exists for punitive damages in wrongful death cases where state law only provides for such damages.

When a settlement includes property damages, the tax treatment depends on the property’s adjusted basis. If the compensation for property damage is less than or equal to the adjusted basis of the property, it is generally not taxable. However, the property’s adjusted basis must be reduced by the settlement amount. If the settlement exceeds the property’s adjusted basis, the excess is considered taxable income.

Any interest received on a settlement or award is generally taxable, regardless of whether the underlying settlement is taxable. This applies to pre-judgment and post-judgment interest that accrues on the settlement amount.

Attorney fees are often paid directly from the gross settlement amount. Even if the plaintiff does not physically receive the attorney’s portion, the entire gross settlement, including attorney fees, is generally considered the plaintiff’s income for tax purposes.

Deducting Expenses Related to Lawsuits

Legal fees and court costs incurred in pursuing a lawsuit can sometimes be deducted, but deductibility rules vary depending on the claim’s nature. For most personal physical injury or sickness lawsuits, where the settlement is non-taxable, related legal fees are generally not deductible. This is because expenses incurred to generate tax-exempt income are typically not deductible.

However, legal fees related to certain whistleblower awards or claims involving unlawful discrimination, such as employment discrimination or civil rights violations, can be deducted “above-the-line.” This deduction reduces an individual’s adjusted gross income (AGI) and is limited to the amount of taxable income received from the settlement in the tax year.

For business-related lawsuits, legal fees are generally deductible as ordinary and necessary business expenses. This applies to legal expenses incurred in operating a trade or business, such as contract disputes or intellectual property litigation. These deductions are typically reported on Schedule C or Schedule E for rental properties.

A common arrangement is a contingency fee, where the attorney’s payment is a percentage of the final settlement. Even if the attorney receives their share directly from the settlement payer, the plaintiff is taxed on the portion of the settlement that went to the attorney, even if they never physically received those funds.

Prior to the Tax Cuts and Jobs Act of 2017, some personal legal fees were deductible as miscellaneous itemized deductions. However, this deduction has been suspended through 2025. This means that for many personal lawsuits, even if a portion of the settlement is taxable, the legal fees associated with obtaining that taxable income may not be deductible.

Reporting Lawsuit Income

When a taxable lawsuit settlement is received, the payer often issues an IRS Form 1099 to both the recipient and the IRS. Common forms include Form 1099-MISC and Form 1099-NEC. Form 1099-MISC is typically used for various taxable settlement payments, often reported as “other income.” Form 1099-NEC is used for nonemployee compensation, such as payments to independent contractors.

The choice of Form 1099 is important, as a Form 1099-NEC can imply self-employment income, potentially subjecting the recipient to self-employment taxes. If a settlement includes both wages (reported on Form W-2) and other taxable income, it is generally preferable for the non-wage portion to be reported on Form 1099-MISC. Any taxable income from a lawsuit settlement must still be reported to the IRS, even if a Form 1099 is not received.

Taxable lawsuit income is reported on Form 1040 or its associated schedules. Interest income is reported on Schedule B. Punitive damages or emotional distress damages not linked to physical injury are typically reported as “Other Income” on Schedule 1. Business-related income from a settlement, such as lost profits, is generally reported on Schedule C.

Receiving a large taxable settlement might necessitate making estimated tax payments throughout the year to avoid underpayment penalties. The IRS requires taxpayers to pay income tax as it is earned, either through withholding or estimated tax payments. If a significant taxable settlement is received, individuals may need to calculate and pay estimated taxes using Form 1040-ES.

Maintaining thorough records is important for tax purposes. Individuals should keep copies of the settlement agreement, attorney invoices, and any Forms 1099 or W-2 received. This documentation helps substantiate the tax treatment of the settlement.