Publication 4345: Taxability of Lawsuit Settlements

Receiving a settlement from a lawsuit can introduce financial questions, particularly regarding tax obligations. IRS Publication 4345 explains the taxability of legal settlements and awards. The guiding principle is the “origin of the claim,” which means the tax treatment of a settlement depends on what the payment is intended to replace. If the payment replaces income that would have been taxed, such as wages, the settlement money is also taxable, while funds for non-taxed items like a physical injury may be non-taxable.

Determining the Taxability of Your Settlement

Compensation received for personal physical injuries or physical sickness is non-taxable. This includes money for medical expenses, hospital bills, and rehabilitation costs related to the physical harm. The non-taxable treatment also extends to compensation for pain and suffering, as long as it originates from a physical injury or sickness. For example, a settlement from a car accident covering medical bills and physical pain is not included in taxable income.

An exception involves medical expenses that were deducted on a prior year’s tax return. If you claimed a deduction for medical expenses and later received a settlement reimbursing you for them, you must include that portion in your income. This is limited to the extent the original deduction provided a tax benefit.

Emotional Distress

The tax treatment of awards for emotional distress depends on its connection to a physical injury. If the emotional distress is a direct result of a physical injury or sickness, the compensation is non-taxable. For instance, funds received for anxiety stemming from physical injuries after an accident are not taxed.

If emotional distress does not originate from a physical injury, the proceeds are taxable. For example, a settlement for defamation causing emotional distress is taxable income. The only portion that may be excluded from income in this scenario is the amount of the award used to pay for medical care related to that emotional distress.

Lost Wages or Profits

Settlement payments that replace lost wages, business profits, or other earned income are taxable. This is because the original income would have been subject to income tax, and these payments are taxed at ordinary income rates. For example, a settlement for back pay in an employment lawsuit is taxable. Receiving a large settlement for lost wages can sometimes push a taxpayer into a higher tax bracket, making tax planning a consideration.

Punitive Damages

Punitive damages are payments intended to punish a defendant for harmful conduct, not to compensate a plaintiff for a specific loss. IRS rules state that punitive damages are taxable income. This is true even if the punitive damages are awarded in a case involving physical injuries or sickness. The clear taxability of punitive damages underscores the importance of having a settlement agreement that clearly allocates payments between compensatory and punitive damages.

Property Damage

Payments received for property damage are not taxable. Instead, these payments are treated as a reduction in the property’s basis, which is its original cost. For example, if your property with a basis of $300,000 is damaged and you receive a $50,000 settlement, you do not report it as income. You simply reduce your basis in the property to $250,000.

Tax implications arise if the settlement amount exceeds your adjusted basis in the property. If the settlement in the previous example was $320,000, the $20,000 that is over your basis would be a taxable capital gain.

Interest

Any interest paid as part of a settlement is always taxable income. Interest can accumulate on an award from the time of the incident until payment is made. This amount is separate from the actual damages and is treated like any other interest income from a bank account or investment.

Required Information and Tax Forms

To accurately report your settlement, you must gather the necessary documentation. The primary document is the settlement agreement, which should provide a clear allocation of the proceeds, specifying amounts for each category like physical injuries or lost wages. The IRS uses this allocation to determine taxability.

You should also collect records that support the claims. For example, have medical bills available for money received for medical expenses. If compensated for property damage, you will need records showing the property’s original cost or adjusted basis. Having this information organized is important for preparing an accurate tax return and for responding to any potential IRS inquiries.

Tax Forms to Expect

After a settlement is finalized, the paying party may send tax forms in January of the following year reporting the taxable income paid to you. One common form is Form 1099-MISC, Miscellaneous Information, which is used to report taxable awards like lost wages or punitive damages. Another form you might receive is Form 1099-INT, Interest Income, which is used if any portion of your settlement was for interest.

How to Report Settlement Income on Your Tax Return

Once you determine which parts of your settlement are taxable, you must report the income on your federal tax return, Form 1040. The specific location depends on the type of income. Taxable damages, such as for lost profits or punitive damages, are reported on the “Other income” line on Schedule 1 (Form 1040). Interest income from a settlement is reported on Schedule B (Form 1040), “Interest and Ordinary Dividends.” A capital gain from a property settlement is reported on Schedule D.

Deducting Attorney Fees and Costs

A frequent question is whether recipients can deduct attorney fees and legal costs. For individuals, legal fees are a miscellaneous itemized deduction. However, the Tax Cuts and Jobs Act of 2017 suspended these deductions through 2025, meaning you cannot deduct attorney fees for most settlements.

This means a taxpayer must pay tax on the gross amount of the settlement, including the portion paid directly to their attorney. For example, if you receive a $100,000 taxable settlement and 40% goes to your attorney, you must report the full $100,000 as income. You cannot deduct the $40,000 in fees, which can significantly reduce the net value of a taxable settlement.

Specific exceptions allow for an “above-the-line” deduction of attorney fees, which reduces your adjusted gross income directly. This deduction is available even if you do not itemize. These exceptions apply to fees and costs for lawsuits involving claims of unlawful discrimination, certain claims against the federal government, and specific whistleblower awards.

If your lawsuit falls into one of these categories, you can deduct the attorney fees on Schedule 1 (Form 1040) as an adjustment to income. This allows you to exclude the attorney’s portion of the settlement from your taxable income.