IRS Publication 4345: Taxability of Lawsuit Settlements

Receiving funds from a lawsuit settlement can create uncertainty about tax obligations. The Internal Revenue Service (IRS) provides guidance in Publication 4345, “Settlements – Taxability,” to help determine if an award is taxable income. The tax treatment depends entirely on the specific facts of the legal case. A settlement can be composed of several elements, like lost wages or emotional distress, and how these are allocated in the agreement is significant, as the IRS respects an allocation if it aligns with the substance of the claims.

The Origin of the Claim Doctrine

The IRS applies the “origin of the claim” doctrine, which dictates that a settlement’s taxability is determined by what the payment was intended to replace. If a lawsuit sought to recover something that would have been taxable, like lost wages, the settlement is also taxable. Conversely, if the settlement compensates for something not taxed, such as making a person whole after a physical injury, the proceeds are not taxable.

The initial legal complaint filed is often considered persuasive evidence of the claim’s origin. Therefore, how a claim is framed from the beginning can have significant tax consequences down the road.

Settlements That Are Not Taxable

Compensation received for “personal physical injuries or physical sickness” is excluded from taxable income. This exclusion covers payments for medical expenses and pain and suffering directly related to the physical injury, such as from a car accident.

If you previously deducted medical expenses related to the injury on a prior year’s tax return, you must include that portion of the settlement in your income. This rule applies only to the extent the prior deduction provided a tax benefit.

Settlements for damage to property also have specific tax treatment. If the payment is less than or equal to your adjusted basis in the property (generally, your original cost plus improvements), the amount is not taxable. It is treated as a “return of capital,” and you must reduce your property’s basis by the amount received. If the settlement exceeds your adjusted basis, the excess is a taxable gain.

Settlements That Are Taxable

When a settlement is intended to replace lost wages or business profits, the funds are taxable as ordinary income. This is because the original income would have been taxed. These payments are often subject to employment taxes like Social Security and Medicare.

Compensation for emotional distress or mental anguish is taxable. An exception exists if the emotional distress is a direct result of a personal physical injury or sickness. In that scenario, the damages for emotional distress are treated as non-taxable.

Punitive damages, which are awarded to punish a defendant rather than to compensate a plaintiff, are taxable even if connected to a physical injury case. The IRS views these payments as an additional financial gain. Any interest paid on a settlement amount is also taxable interest income.

Reporting Settlement Income and Deductions

When you receive a taxable settlement, you may receive an informational tax form from the payer, such as a Form 1099-MISC, 1099-INT, or 1099-NEC. These forms report the amount paid to you and your attorney to the IRS.

You must report the full, gross amount of the taxable settlement on your tax return, even the portion that went to your attorney for fees. Taxable income is reported as “Other Income” on Schedule 1 of Form 1040, or on Schedule C if it relates to your business.

For individuals, most legal fees are considered a miscellaneous itemized deduction, which was suspended by the Tax Cuts and Jobs Act of 2017 through 2025. However, an exception allows certain legal fees to be deducted “above-the-line” as an adjustment to income, meaning you can take the deduction even if you do not itemize. This applies to attorney’s fees related to claims of unlawful discrimination, certain whistleblower claims, and specific claims against the U.S. government.