How Is a Settlement Taxed by the IRS?

A settlement resolves a legal dispute outside of a courtroom, typically involving an agreement to pay or receive funds. The tax treatment of these proceeds can be complex and depends on the original claim. Understanding this is important for accurate tax reporting.

Understanding the Basis of Taxation

The Internal Revenue Service (IRS) applies the “origin of the claim” doctrine to determine if settlement proceeds are subject to taxation. This principle means the tax treatment depends on what the payment replaces, not the lawsuit’s label or initial injury claim. If the settlement compensates for income that would have been taxable, such as lost wages, the settlement amount is taxable. Conversely, if it replaces a non-taxable item, like compensation for physical injury, the settlement is not taxable.

The focus is on the underlying reason for the payment. For example, a settlement for lost business profits is taxable because those profits, if earned normally, would have been subject to income tax. A settlement for medical expenses incurred due to a physical accident, however, would not be taxable because it compensates for an expense rather than lost income. The characterization of settlement funds directly influences their tax implications.

Common Taxable Settlement Amounts

Lost wages or profits are subject to income tax as ordinary income because they replace earnings that would have been taxed if earned normally. For instance, if an employment dispute settlement includes an amount for lost salary, that portion is taxable income. This applies to lost income from a job or business.

Punitive damages, awarded to punish wrongdoers, not to compensate for a loss, are taxable. This is true regardless of the underlying claim, even if it involves physical injury. The IRS views punitive damages as an addition to wealth and are taxable.

Compensation for emotional distress is taxable as ordinary income unless it directly results from a physical injury or physical sickness. If the emotional distress is not linked to a physical injury, such as distress from a defamation lawsuit without physical harm, the settlement portion allocated to it will be taxed. The physical injury or sickness must be observable, not merely symptoms of emotional distress, for this exclusion to apply.

Any interest awarded on a judgment or settlement amount is taxable as ordinary income. This interest accrues from the date damages occurred or the lawsuit was filed until payment. The IRS considers this interest as compensation for the delay in receiving the funds, similar to savings account interest.

Attorney fees have tax implications for the recipient of a settlement. If attorney fees are paid from a taxable portion of the settlement, the full settlement amount, including the portion designated for attorney fees, is considered gross income to the recipient. The taxpayer may then deduct these fees as an itemized deduction, subject to limitations.

Common Non-Taxable Settlement Amounts

Compensation received on account of physical injury or physical sickness is excluded from gross income under Internal Revenue Code Section 104. This applies to damages for actual physical injuries, such as a broken bone or severe burn. These payments restore the taxpayer to their previous physical state, rather than adding to wealth.

Medical expenses related to a physical injury or sickness are non-taxable when received as part of a settlement. This includes payments for hospital stays, doctor visits, medications, and rehabilitation directly resulting from the injury. These funds reimburse costs incurred due to the injury.

Settlements for property damage are not taxable up to the adjusted basis of the property. The adjusted basis is the original cost plus improvements, minus depreciation. For example, if a car with an adjusted basis of $15,000 is damaged and a settlement of $12,000 is received, that amount is not taxable.

If the compensation for property damage exceeds the adjusted basis, the excess amount is taxable as a gain. This occurs when the settlement provides a profit beyond the asset’s cost. For instance, if the same car had an adjusted basis of $10,000 and the settlement was $12,000, the $2,000 difference is a taxable gain.

Workers’ compensation benefits received for an occupational sickness or injury are excluded from gross income. This applies to payments made under a workers’ compensation act or statute for personal injuries or sickness. These benefits provide income replacement and medical coverage for work-related incidents.

Reporting Settlements to the IRS

When a settlement is paid, the payer may issue Form 1099-MISC to report certain types of income. For settlements, this form reports taxable amounts in Box 3, “Other Income,” if $600 or more. The payer must send this form to the recipient and the IRS by specific deadlines, usually in January of the year following payment.

In some employment-related disputes involving lost wages from an employer, a W-2 may be issued instead of a 1099-MISC. This indicates the employer treated lost wages as regular compensation, withholding federal income, Social Security, and Medicare taxes. The W-2 includes these amounts in Box 1, “Wages, tips, other compensation,” and shows taxes withheld.

Even if a portion of a settlement is non-taxable, such as for physical injury, maintain meticulous records. While non-taxable amounts are not reported on a 1099-MISC, taxpayers should keep documentation to substantiate the non-taxable nature of funds if questions arise from the IRS. This documentation clarifies the purpose of settlement payments.

For property damage settlements, tax basis recovery is important for reporting. Only the amount exceeding the property’s adjusted basis is a taxable gain. Taxpayers must track their property’s basis to determine any taxable portion.

Taxpayers should retain all settlement agreements, legal documents, and correspondence related to the dispute. These records provide evidence supporting the tax position on settlement proceeds. Maintaining thorough documentation fulfills tax obligations and helps respond to IRS inquiries.