Do You Pay Taxes on Money From a Lawsuit?

Money from a lawsuit settlement or judgment can seem like a windfall, but its tax treatment is often complex and depends on several factors. The Internal Revenue Service (IRS) considers all income taxable unless specifically excluded by law. This principle applies to lawsuit proceeds, meaning not all settlement money is treated the same for tax purposes. Understanding the nature of damages awarded and other settlement components is important to determine what portion, if any, you may need to report as income.

Understanding Taxable and Non-Taxable Damages

The taxability of lawsuit damages primarily hinges on the claim’s origin and the specific type of damages received. Federal tax law excludes from gross income damages received due to physical injury or sickness.

This exclusion covers compensation for medical expenses, pain and suffering, emotional distress directly resulting from physical injury, and even lost wages if directly attributable to physical injury or sickness. For example, a settlement for a car accident causing a broken leg and associated medical bills, the portion covering those medical costs and pain would not be subject to federal income tax.

Damages for emotional distress are taxable unless originating from a physical injury or sickness. If you receive compensation for emotional distress or mental anguish not directly linked to a physical injury, such as in a defamation case where no physical harm occurred, that portion of your settlement is taxable.

Lost wages or lost profits compensated through a lawsuit are taxable income. This compensation replaces income that would have been taxable if earned in the normal course of employment or business. For instance, if a wrongful termination lawsuit includes an award for back pay or future lost earnings, these amounts are considered taxable just as your regular salary would have been. This principle applies regardless of whether lost wages are part of a settlement for physical injury or another type of claim.

Punitive damages, awarded to punish the wrongdoer and deter similar conduct, are always taxable. This holds true even if received in physical injury or sickness cases. The IRS does not allow an exclusion for punitive damages, viewing them as income rather than compensation for a loss. Any portion of a settlement or judgment designated as punitive damages will be included in your taxable income.

Interest awarded on a judgment or settlement is also taxable income. This interest, whether statutory or prejudgment, compensates for delayed receipt of money, not the underlying injury or loss. For example, if a court awards you $100,000 in damages plus $5,000 in interest accrued during the lawsuit, that $5,000 interest portion would be taxable. This applies even if the underlying damages were non-taxable, such as those for a physical injury.

Treatment of Legal Fees and Other Settlement Components

Legal fees and other expenses associated with a lawsuit settlement have specific tax treatments that can significantly affect the net amount you receive and your tax liability. When you receive a taxable settlement, the entire gross amount of the taxable damages is considered your income, even if a portion is immediately paid to your attorney as a contingent fee.

This concept, known as the “assignment of income” doctrine, means you are taxed on the full amount before the attorney’s fees are deducted. For example, if you receive a $100,000 taxable settlement and your attorney takes $30,000, you are considered to have received $100,000 for tax purposes.

While the full gross amount of taxable damages is considered income, there are specific circumstances where you may be able to deduct legal fees. For certain types of cases, primarily those involving whistleblower awards, unlawful discrimination, or specific civil rights claims, you may deduct attorney fees as an “above-the-line” deduction. This means the deduction reduces your adjusted gross income (AGI), which can be beneficial for various tax calculations.

For most other taxable lawsuit settlements, legal fees were previously deductible as a miscellaneous itemized deduction. However, the Tax Cuts and Jobs Act (TCJA) of 2017 suspended these miscellaneous itemized deductions, subject to the 2% of AGI limitation, for tax years 2018 through 2025. This suspension means that for many taxpayers, legal fees paid for obtaining a taxable settlement are not currently deductible. Consequently, you could be taxed on the gross settlement amount without being able to offset the attorney’s fees, potentially leading to a higher tax burden.

Structured settlements involve payments received over a period of time rather than a single lump sum. The tax treatment of these periodic payments depends on the taxability of the underlying damages. If the settlement is for physical injury or physical sickness, meaning the original lump sum would have been non-taxable, then the periodic payments from a structured settlement are also non-taxable. This allows tax-free income over time.

However, if the underlying damages are taxable, such as for lost wages or emotional distress not related to physical injury, then the periodic payments from a structured settlement will also be taxable. Each payment is treated as taxable income when received. Court costs and other litigation expenses, such as expert witness fees or filing fees, are treated similarly to legal fees. If they are directly related to obtaining a taxable settlement, their deductibility often falls under the same rules as attorney fees, meaning they may not be deductible for many taxpayers during the current suspension of miscellaneous itemized deductions.

Reporting Lawsuit Income

After determining which portions of your lawsuit settlement are taxable, the next step involves properly reporting these amounts to the Internal Revenue Service. You may receive various tax forms from the payer of your settlement, IRS Form 1099-MISC, Miscellaneous Income, or Form 1099-NEC, Nonemployee Compensation.

Form 1099-MISC reports various types of income, including certain taxable lawsuit proceeds, while Form 1099-NEC specifically reports nonemployee compensation, which could include payments for lost wages if you were an independent contractor. These forms show the total amount paid, with a copy sent to the IRS.

When reporting taxable lawsuit income on your federal income tax return, the specific form and line item depend on the nature of the income. For instance, taxable damages for lost wages might be reported on Schedule 1 (Additional Income and Adjustments to Income) of Form 1040 as “Other Income” or potentially as self-employment income on Schedule C (Profit or Loss from Business) if the lost wages relate to an independent contractor business. Punitive damages and emotional distress damages not related to physical injury are also reported on Schedule 1 as “Other Income.”

If you are able to deduct legal fees, such as for whistleblower or discrimination cases, this deduction would be reported on Schedule 1 of Form 1040, reducing your adjusted gross income. Match income reported on Forms 1099 with amounts on your tax return. If you receive a large taxable settlement, you may be required to pay estimated taxes throughout the year to avoid underpayment penalties. The U.S. tax system operates on a pay-as-you-go basis, and significant amounts of taxable income not subject to withholding, like many lawsuit settlements, often necessitate making quarterly estimated tax payments using Form 1040-ES.

Due to the intricate rules surrounding lawsuit settlements, including the origin of the claim, the types of damages received, and the deductibility of legal fees, consulting with a qualified tax professional is recommended. A tax professional can help you accurately determine the taxable portion of your settlement, identify any available deductions, and ensure proper reporting on your federal income tax return. This guidance can help prevent errors and potential penalties from the IRS.