How Is Settlement Money Taxed by the IRS?

Settlement money, received as a result of a lawsuit or agreement, can provide financial relief. Understanding the tax implications of these funds is essential, as the taxability of settlement proceeds varies widely depending on the nature of the claim and the specific components of the award. While some settlement amounts may be entirely tax-free, other portions could be fully taxable as ordinary income.

General Taxability Rules

The Internal Revenue Service (IRS) operates under the principle that all income, regardless of its source, is taxable unless a specific provision in the tax code explicitly excludes it. This rule applies to settlement money, which is presumed taxable unless an exception applies.

An exception involves settlements for personal physical injuries or sickness. If the settlement compensates for observable bodily harm, such as injuries from a car accident, slip and fall, or medical malpractice, these funds are not taxable income. This exclusion applies to damages for physical injuries or sickness, as outlined in Section 104. Emotional distress directly linked to a physical injury or sickness is also excludable from gross income.

Specific Taxable and Non-Taxable Settlement Components

The tax treatment of settlement components depends heavily on what the payment is intended to compensate. Different types of damages within a settlement are subject to distinct tax rules. Understanding these distinctions is crucial for proper tax planning and reporting.

Emotional distress awards are taxable if they are not directly linked to a physical injury or physical sickness. For instance, compensation for emotional distress arising from defamation, discrimination without physical injury, or wrongful termination is considered taxable income. However, if the emotional distress is a direct consequence of a personal physical injury or physical sickness, the compensation for that emotional distress is not taxable.

Compensation for lost wages or lost profits is taxable as ordinary income. This applies regardless of the underlying claim, whether it stems from a personal injury case, employment dispute, or breach of contract. These amounts are subject to income tax, and potentially Social Security and Medicare taxes, depending on the nature of the employment.

Punitive damages, which are awarded to punish a defendant for egregious conduct rather than to compensate the injured party, are always taxable. This rule applies even if the punitive damages are received in a case involving physical injuries or sickness. Any interest awarded on settlement money, whether pre-judgment or post-judgment interest, is taxable as ordinary income.

Settlements for property damage are not taxable if the amount received does not exceed the adjusted basis of the property. The adjusted basis represents the original cost of the property plus improvements, minus depreciation. If the settlement amount exceeds the property’s adjusted basis, the excess is considered a taxable gain.

Regarding attorney fees, the full settlement amount, including the portion paid to the attorney, is considered gross income to the plaintiff. This is true even if the attorney’s fees are paid directly to the attorney by the defendant. Settlements for claims such as employment discrimination, breach of contract, or wrongful termination are taxable as ordinary income, as they often compensate for lost wages or other economic losses.

Reporting Settlement Income

Reporting settlement income to the IRS is important for recipients. The method of reporting depends on the type of income received and who is making the payment. Even if a portion of a settlement is not taxable, recipients are responsible for understanding their reporting obligations.

One common form for reporting settlement income is Form 1099-MISC, Miscellaneous Information. This form is issued when payments are made for non-employee compensation, rents, or other types of income, which can include taxable settlement components like emotional distress not linked to physical injury, punitive damages, or interest. If a settlement includes a portion for lost wages or other compensation that an employer would report, it is reported on Form W-2, Wage and Tax Statement. This occurs when the settlement is considered a substitute for wages subject to employment taxes. For certain non-employee compensation, Form 1099-NEC, Nonemployee Compensation, may be used.

Recipients are responsible for reporting all taxable income, even if they do not receive a specific tax form like a 1099. The absence of a form does not negate the taxability of the income. Due to the varied and complex tax treatment of different settlement components, consulting a qualified tax professional is advisable. They can help determine which portions of a settlement are taxable and ensure accurate reporting to the IRS.

Deducting Legal Expenses

The deductibility of legal expenses incurred to obtain a settlement has specific rules that vary based on the nature of the claim. For individuals, the Tax Cuts and Jobs Act (TCJA) of 2017 changed the rules for deducting legal fees. Under this law, most miscellaneous itemized deductions subject to a 2% adjusted gross income (AGI) limitation, including many legal fees related to personal claims, are suspended through 2025. This means that legal fees for personal injury cases or other non-business-related settlements are not deductible for individuals during this period.

However, exceptions exist. Legal fees related to certain “above-the-line” deductions may still be deductible, meaning they can reduce a taxpayer’s gross income before calculating AGI. This includes legal fees paid in connection with whistleblower claims, unlawful discrimination claims, and certain civil rights cases. For example, attorney fees related to employment discrimination lawsuits are deductible.

Legal fees incurred for business-related settlements are deductible as ordinary and necessary business expenses. This applies to fees paid to defend or protect a business, collect business income, or acquire business assets. Maintaining thorough records of all legal fees and settlement documentation is important. This documentation helps substantiate any deductions claimed and can be important if the IRS has questions about the tax treatment of the settlement or associated expenses.