Is Lawsuit Money Taxable? Here’s What to Know

Receiving money from a lawsuit can bring financial relief, but understanding its tax implications is important. The taxability of lawsuit proceeds is not always straightforward, depending heavily on the nature of the original claim and the specific types of damages awarded. The Internal Revenue Service (IRS) generally considers all income taxable unless a specific exclusion is provided by law.

General Taxability Overview

The “origin of the claim” doctrine is the fundamental principle guiding the taxability of lawsuit settlements and awards. This doctrine dictates that the IRS examines the underlying reason for the lawsuit and the nature of the damages the payment is intended to replace, rather than the form or terminology used in the settlement agreement. Under Internal Revenue Code Section 61, all income is considered taxable unless specifically exempted.

The IRS’s default position is that all income is taxable unless a specific exclusion applies. Taxpayers generally bear the burden of proof to demonstrate that a portion of their settlement is non-taxable. Even if a settlement agreement attempts to characterize payments, the IRS may look beyond it to the actual intent and nature of the original claim to determine taxability.

Non-Taxable Lawsuit Proceeds

Certain types of lawsuit proceeds are generally not subject to federal income tax. The primary exclusion applies to damages received on account of personal physical injuries or physical sickness, as outlined in Internal Revenue Code Section 104. This means compensation for observable bodily harm, such as injuries from a car accident, a slip and fall, or medical malpractice, is typically tax-free. The injury must be physical, such as a broken bone or a diagnosed illness, rather than purely emotional.

Emotional distress damages are generally non-taxable only if directly attributable to a physical injury or physical sickness. For instance, if emotional distress arises as a direct consequence of a car accident that caused physical injuries, the damages for that emotional distress may be excludable. However, emotional distress damages not stemming from a physical injury or sickness are typically taxable.

Compensation for property damage is generally not taxable up to the original adjusted basis of the property, as it is considered a return of capital. This principle means the payment restores the value lost, rather than providing a gain. If the settlement for property damage is less than or equal to the property’s adjusted basis, it is typically not taxable and does not need to be reported as income.

Taxable Lawsuit Proceeds

Many types of lawsuit proceeds are generally subject to federal income tax. Punitive damages, which are awarded to punish the defendant rather than compensate for actual losses, are almost always taxable, regardless of the nature of the underlying claim. This holds true even if they are awarded in conjunction with tax-free compensatory damages for physical injuries. The IRS views punitive damages as a penalty and not a reimbursement for a loss, making them taxable income.

Lost wages and lost profits are taxable as ordinary income because they are intended to replace income that would have been taxable if earned normally. This includes compensation for back pay or unpaid wages, which the IRS treats similarly to regular employment income, subjecting it to income and employment taxes. Damages for emotional distress not stemming from a physical injury or sickness, such as those from defamation, discrimination, or breach of contract, are also taxable. These types of emotional distress are not considered physical injuries for tax purposes unless they are specifically for medical care attributable to such distress.

Any interest earned on a judgment or settlement is taxable as ordinary income, regardless of whether the underlying award is taxable or non-taxable. This interest is typically reported as interest income on a tax return. For most types of taxable lawsuit proceeds, the entire gross amount of the award is considered income to the claimant, even if attorney’s fees are deducted directly from the settlement. This means the taxpayer is generally responsible for taxes on the full settlement amount before legal fees are subtracted. If the property damage settlement amount exceeds the adjusted basis of the property, the excess is considered a taxable gain.

Reporting Lawsuit Income

Taxable lawsuit proceeds must be reported on your federal income tax return. Settlement administrators or payers may issue different tax forms depending on the payment’s nature. For miscellaneous income, such as emotional distress damages or punitive damages, a Form 1099-MISC may be issued. If the settlement includes lost wages treated as employment income, a Form W-2 might be provided. It is important to review these forms carefully, as copies are also sent to the IRS.

Taxable miscellaneous income reported on Form 1099-MISC is generally reported on Schedule 1 of Form 1040 as “Other Income.” Lost wages reported on a W-2 are included as wages on Form 1040. Maintaining thorough records is crucial for determining correct tax treatment and substantiating claims to the IRS. This documentation should include the settlement agreement, court documents, and any related correspondence, especially if the settlement allocates funds to different types of damages. For complex cases or significant settlements, consulting a qualified tax professional or attorney is highly recommended to ensure proper tax treatment and compliance.