Do You Pay Taxes on Settlement Money?

Whether settlement funds are taxable depends on the specific nature of the claim for which the payment is received. The Internal Revenue Service (IRS) generally considers all income taxable unless explicitly excluded by law, and this principle extends to settlement proceeds.

The taxability of settlement money is determined by the “origin of the claim” doctrine. This means the reason for receiving the money dictates its tax status. For instance, compensation for lost wages is treated differently than funds received for physical injuries.

Settlements Generally Subject to Tax

Many settlement proceeds are considered taxable income, as they replace income that would have been taxable if earned normally. Compensation for lost wages or profits, whether past or future, falls into this category. If you receive a settlement that includes payments for income you would have earned, that portion is generally subject to income tax.

Settlements for emotional distress are usually taxable if the distress did not originate from a physical injury or physical sickness. For example, if you receive money for emotional distress resulting from defamation, discrimination without physical harm, or a breach of contract, these funds are typically includible in your gross income. The IRS distinguishes between emotional distress linked to a physical ailment and that which is purely psychological.

Punitive damages are almost always taxable, regardless of the nature of the underlying claim. These damages are awarded to punish the wrongdoer and deter similar conduct, rather than to compensate for actual losses. Even if the settlement is for a physical injury, any amount designated as punitive damages will be subject to federal income tax.

Damages received for injury to reputation, such as defamation, are generally taxable unless directly linked to a physical injury or sickness. If the reputational harm caused no physical injury, the settlement amount is considered gross income. Similarly, settlements for breach of contract, particularly if they compensate for lost profits or income, are typically taxable.

Employment discrimination settlements often include components for back pay and front pay, which are taxable as wages. Understanding the allocation of funds within an employment settlement is important for accurate tax reporting.

Settlements Generally Exempt from Tax

Damages received on account of personal physical injuries or physical sickness are generally excluded from gross income. Payments for medical expenses, lost wages directly attributable to the physical injury or sickness, and pain and suffering are generally excluded. This exclusion applies whether the payment is received through a lawsuit or an out-of-court settlement.

The distinction for this exemption is the direct link to a physical injury or sickness. Emotional distress damages are non-taxable if they are directly caused by and are part of the recovery for a physical injury or physical sickness.

Reimbursement for medical expenses, including those paid by you or covered by insurance, is typically non-taxable when received as part of a settlement. This applies to payments for past and future medical care necessitated by the physical injury or sickness.

Settlements for damage to property are generally non-taxable up to the adjusted basis of the property. The adjusted basis represents your cost in the property for tax purposes, often the original purchase price plus improvements, minus any depreciation. If the settlement amount for property damage exceeds this adjusted basis, the excess amount may be taxable as a gain.

Workers’ compensation benefits are generally tax-exempt income. Payments received under a workers’ compensation act or statute for occupational sickness or injury are typically excluded from gross income. This exclusion covers payments for loss of wages and medical expenses related to the work-related injury.

Understanding Specific Tax Implications

Attorney fees can significantly impact the net amount received from a settlement and have specific tax considerations. When attorney fees are deducted from the settlement before the client receives the funds, the gross amount of the settlement, including those fees, may still be considered taxable income to the client. This means you might be taxed on money you never physically received.

For certain types of cases, such as employment discrimination lawsuits, there may be an above-the-line deduction available for attorney fees. This deduction helps offset the income inclusion, reducing your adjusted gross income. Consulting with a tax professional is beneficial to determine if this deduction applies to your specific situation.

Any interest awarded on a settlement is almost always taxable, regardless of whether the underlying settlement amount is taxable. Interest is considered compensation for the delay in receiving the funds and is treated as ordinary income. This applies even if the core settlement funds are exempt from tax due to physical injury.

Structured settlements involve periodic payments rather than a single lump sum. If a structured settlement is for personal physical injuries or physical sickness, the periodic payments are generally non-taxable, similar to a lump-sum payment for the same type of injury. This allows the injured party to receive tax-free income over time.

Certain taxable settlement payments may be reported to the IRS on Form 1099-MISC, for miscellaneous income, or Form 1099-NEC, for nonemployee compensation. Receiving a 1099 form indicates that the payer has reported the payment to the IRS, but it does not automatically mean the entire amount is taxable. You should still determine the taxable portion based on the origin of the claim. It is prudent to consult with a tax professional or an attorney experienced in settlement taxation before agreeing to a settlement, especially for larger or complex cases. This helps you understand the potential tax consequences and plan accordingly.