Do You Pay Taxes on Legal Settlements?

The taxation of legal settlements is a nuanced area of tax law. While some proceeds are tax-exempt, many are taxable. Taxability depends on the claim’s nature and the types of damages received. Understanding these distinctions is important for tax planning.

Settlements Exempt from Taxation

Certain legal settlements are not subject to federal income tax, primarily those related to personal physical injury or sickness. Damages for physical personal injury or sickness are excludable from gross income under Internal Revenue Code Section 104. This applies when injuries directly result from an incident, like a broken bone from a slip and fall. The IRS requires the injury to be physical for the settlement to be tax-free.

Emotional distress damages can also be tax-free if directly linked to a physical injury or sickness. For example, if emotional distress arises from a physical injury, compensation for both may be excluded. The physical injury must be the claim’s origin. Medical expense reimbursements are also not taxable, if not previously deducted.

Settlements for property damage are not taxable if the amount received does not exceed the property’s adjusted basis. This is considered a return of capital. If the settlement exceeds the adjusted basis, the excess is taxable income. Tax treatment aligns with the “origin of the claim,” meaning what the settlement replaces.

Settlements Subject to Taxation

Many legal settlements are subject to federal income tax, unlike those for physical injury. Punitive damages are always taxable, regardless of the underlying claim. They are reported as “Other Income.”

Emotional distress damages not directly linked to a physical injury or sickness are taxable. Physical symptoms like headaches or insomnia are not considered physical injuries for tax exclusion unless directly caused by one. Compensation for lost wages, lost profits, or other income replacement is taxable as ordinary income, including back pay and front pay.

Settlements for claims like defamation, discrimination, or breach of contract are taxable because they do not arise from physical injury or sickness. Any interest awarded is always taxable, regardless of the primary settlement’s taxability. Attorney fees paid from a taxable settlement portion are considered part of the recipient’s gross income, even if paid directly to the attorney.

Reporting Settlement Income to the IRS

Recipients of taxable legal settlements must report this income to the IRS. The payer typically reports income using IRS forms, such as Form 1099-NEC or Form 1099-MISC. Lost wages from an employer might be reported on a Form W-2.

Taxable income must be reported on the individual’s tax return, typically Form 1040. Taxable lost wages are reported as wages. Other taxable amounts, like punitive damages or emotional distress not linked to physical injury, are reported as “Other Income.” If property damage compensation exceeds the adjusted basis, the excess is reported as income.

The settlement agreement is important for tax purposes, as it should delineate settlement components and their purposes. The IRS respects allocations in an agreement if they align with the underlying claims. For large taxable settlements, estimated tax payments may be necessary to avoid underpayment penalties.

Tax Treatment of Attorney Fees

If attorney fees are paid from a taxable settlement portion, the full settlement amount, including the portion paid directly to the attorney, is considered gross income to the client.

However, attorney fees may be deductible “above the line” in certain cases, such as whistleblower awards or unlawful discrimination lawsuits. For these cases, fees can reduce the taxpayer’s taxable income.

For most other taxable settlements, attorney fees are not deductible for individuals under current tax law. This means the client reports the entire taxable portion as income without deducting those fees. Understanding the attorney fee agreement is important for overall tax liability.

Understanding Structured Settlements

Structured settlements provide periodic payments instead of a single lump sum. The tax implications depend on the underlying claim’s taxability.

If the original claim is for personal physical injury or sickness, periodic payments from a structured settlement are tax-free. This applies to both the principal and any earnings.

If the underlying claim is taxable, such as lost wages or punitive damages, periodic payments are taxable as ordinary income when received. Structured settlements offer tax deferral, spreading liability over multiple years.