When Are Compensatory Damages Taxable?

Compensatory damages are payments designed to restore an injured party to their prior financial position. When a legal settlement or court judgment is awarded, its tax implications are a common concern. The Internal Revenue Service (IRS) has specific rules that determine whether these awards are taxable income, and the treatment depends on the nature of the claim that led to the award.

The Origin of the Claim Test

The foundation of how the IRS treats settlement awards is the “origin of the claim” test. This principle dictates that the taxability of the money received depends on what the payment is intended to replace. If the damages replace something that would have been taxed, then the award itself is taxable.

For example, a payment for lost wages is taxed just like the wages would have been. This framework requires an analysis of the legal claims made, the issues involved, and the stated purpose of the litigation. This concept provides the underlying logic for how different types of compensatory damages are taxed.

Tax Rules for Common Damage Awards

Physical Injuries and Physical Sickness

Under Internal Revenue Code (IRC) Section 104, damages received for personal physical injuries or physical sickness are excluded from gross income, making them non-taxable. This exclusion applies whether the payment is a lump sum or in periodic installments and includes compensation for medical bills. The exclusion also extends to damages for pain and suffering, as long as they directly result from the physical injury. For the injury to be considered “physical,” the IRS looks for observable bodily harm.

Emotional Distress

The tax treatment for emotional distress damages depends on its connection to a physical injury. Damages awarded for emotional distress alone are considered taxable income, including compensation for symptoms like insomnia or headaches. An exception exists if the emotional distress is directly attributable to a physical injury that was the basis of the claim.

In that case, the damages for that distress are also excluded from income under the same tax rule. For example, if a car accident causes physical injuries and subsequent anxiety, compensation for both would be non-taxable. A further exception allows for the non-taxable recovery of amounts paid for medical care related to emotional distress, even if it is not from a physical injury.

Lost Wages or Business Profits

Payments that compensate for lost wages or lost business profits are taxable as ordinary income. These awards replace income that would have been taxed if earned through normal employment or business operations. In many employment-related lawsuits, a portion of the settlement allocated to lost wages is treated like regular wages and may be reported on a Form W-2. For self-employed individuals, a payment for lost profits would be reported as business income.

Punitive Damages

Punitive damages are not intended to compensate for a loss but to punish the wrongdoer for egregious conduct. The IRS considers punitive damages to be taxable income. This rule applies even if the punitive damages are awarded in a case involving physical injuries. For instance, if a person receives $50,000 in compensatory damages for a physical injury and $1 million in punitive damages, the $50,000 is tax-free, but the entire $1 million is taxable.

Interest

Any interest paid on a settlement award or judgment is always taxable as interest income. This is true regardless of whether the underlying award itself is taxable or tax-free. The IRS views interest as payment for the time the recipient had to wait for the money, which is unrelated to the origin of the legal claim. The payer will issue a Form 1099-INT to report this portion of the payment.

Reporting Procedures and Related Tax Considerations

Expected Tax Forms

When you receive a taxable settlement of $600 or more, the paying party is required to report it to you and the IRS. You can expect to receive a Form 1099-MISC, Miscellaneous Information, showing the taxable amount in Box 3, “Other income.” If the settlement includes taxable interest, you will receive a Form 1099-INT for that amount. In some employment-related cases, the employer might report back pay on a Form W-2, Wage and Tax Statement, and withhold income and employment taxes.

How to Report on Your Tax Return

The information from these forms must be transferred to your Form 1040 tax return. Taxable damages from a Form 1099-MISC are entered on Schedule 1 as “Other Income.” Interest income from a Form 1099-INT is reported on Schedule B. If you received a Form W-2, that income is reported on the wages line of your Form 1040. Non-taxable portions of an award do not need to be reported on your tax return.

Treatment of Attorney’s Fees

The tax treatment of attorney’s fees is a significant consideration, especially with contingent fee arrangements. The Supreme Court’s ruling in Commissioner v. Banks established that a plaintiff is taxed on the gross amount of a taxable settlement, before legal fees are deducted. If you receive a $100,000 taxable settlement and your attorney’s fee is $40,000, you are considered to have received $100,000 in income, not the $60,000 you take home.

For most personal injury cases, legal fees are a miscellaneous itemized deduction, which was suspended for tax years 2018 through 2025 by the Tax Cuts and Jobs Act. This means you cannot deduct the attorney’s fees, resulting in a tax liability on money that went to your lawyer. An exception exists for claims related to employment and certain whistleblower cases, where legal fees can often be deducted “above the line,” which is more favorable.

Importance of the Settlement Agreement

The language in the final settlement agreement is important for tax purposes. A well-drafted agreement will clearly allocate the payment among different claims, such as non-taxable physical injury damages and taxable lost wages. While the IRS is not bound by these allocations, a reasonable and clear allocation provides strong evidence of the parties’ intent. If an agreement is silent on the allocation, the IRS will look to the payor’s intent to determine the tax character of the payments.