When Does Lawsuit Money Get Taxed by the IRS?

Lawsuit money, encompassing settlements, judgments, and awards, can provide financial relief, but its taxability by the Internal Revenue Service (IRS) is often complex. The tax implications depend heavily on the specific nature of the claim that led to the payment and the type of damages received. Understanding these distinctions is important for anyone receiving such funds. This article clarifies the various tax treatments of lawsuit money.

General Taxability Rules for Settlements and Awards

The fundamental principle guiding the taxability of lawsuit money is that all income, regardless of its source, is considered taxable unless a specific legal exclusion applies. This rule is established under Internal Revenue Code Section 61, which defines gross income. Therefore, any financial gain from a lawsuit is presumed taxable unless explicitly exempted by another section of the tax code.

The IRS primarily uses the “origin of the claim” doctrine, which states that the tax treatment of a settlement or award is determined by the nature of the claim for which the funds were originally sought. If the underlying claim was for something that would have been taxable income, such as lost wages, the settlement replacing that income is generally taxable. Conversely, if the claim was for something non-taxable, like a physical injury, the corresponding settlement is likely non-taxable.

Damages Not Subject to Tax

Certain types of damages received from a lawsuit are excluded from gross income and are therefore not subject to federal income tax. The most significant exclusion applies to damages received on account of personal physical injuries or physical sickness. This exclusion is provided under Internal Revenue Code Section 104. For this exclusion to apply, there must be observable bodily harm or a diagnosed physical ailment.

Damages for emotional distress are generally non-taxable only if they are directly attributable to a physical injury or physical sickness. If emotional distress arises as a direct consequence of a physical injury, the compensation for that emotional distress can be excluded from income. However, if the emotional distress is not linked to a physical injury, it is typically taxable.

The exclusion for physical injuries encompasses various forms of compensation, including amounts for medical bills, pain and suffering, and even lost wages if they are a direct result of the physical injury. For example, settlements from motor vehicle accidents, slip and fall incidents, and medical malpractice cases often fall into this non-taxable category when they involve observable bodily harm.

Taxable Damages

Many types of lawsuit proceeds are considered taxable income by the IRS, as they replace income that would have otherwise been taxed. Lost wages and lost profits are consistently taxable. If a lawsuit settlement compensates for income that would have been earned, such as back pay, front pay, or business profits, these amounts are treated as taxable income.

Punitive damages are always taxable, regardless of the nature of the underlying claim. These damages are awarded to punish the defendant for egregious conduct rather than to compensate the plaintiff for a loss. Even if the lawsuit involves a physical injury that is otherwise non-taxable, any portion allocated to punitive damages remains fully taxable.

Interest awarded on a judgment or settlement is also taxable. This applies to both pre-judgment interest (accrued before the final award) and post-judgment interest (accrued after the award but before payment).

Damages for emotional distress or mental anguish are taxable if they are not directly linked to a personal physical injury or physical sickness. This category often includes emotional distress arising from claims of discrimination, defamation, or reputation harm.

Settlements for property damage are generally not taxable to the extent they reimburse the adjusted basis of the damaged property. However, any amount received above the adjusted basis is considered a taxable gain. This taxable gain may be reported as a capital gain on Schedule D or as ordinary income.

If a defendant directly pays a plaintiff’s attorney’s fees as part of a settlement, these fees are generally considered taxable income to the plaintiff, even if the plaintiff never physically receives the funds.

Handling Legal Fees and Related Expenses

The tax treatment of legal fees and other litigation expenses can be complex, especially for individual taxpayers. Under current tax law, specifically the Tax Cuts and Jobs Act of 2017, many miscellaneous itemized deductions have been suspended until 2026. This means that for most individuals, legal fees related to personal injury lawsuits or other non-business claims are generally not deductible.

There are important exceptions where legal fees may still be deductible. Legal fees incurred in connection with a trade or business are generally deductible as ordinary and necessary business expenses. Legal fees for certain whistleblower awards are also deductible. Additionally, legal fees paid in connection with claims of unlawful discrimination are deductible under Internal Revenue Code Section 62.

If legal fees are deductible under these exceptions, they are typically taken as an “above-the-line” deduction, meaning they reduce gross income to arrive at adjusted gross income. This type of deduction is more advantageous than an itemized deduction because it is not subject to the limitations that apply to itemized deductions. The deduction cannot exceed the amount of the judgment or settlement included in income for the tax year.

Reporting Lawsuit Income

When a lawsuit settlement or award is received, the payer (often the defendant or their insurance company) may issue specific tax forms to the recipient and the IRS. Form 1099-MISC is commonly used for various settlement payments, including emotional distress (not linked to physical injury) and punitive damages, typically reported in Box 3 as “other income.” Form 1099-NEC might be issued if the payment is considered compensation for services. If the settlement includes lost wages from an employment context, a portion may be reported on Form W-2.

Recipients must report taxable lawsuit income on their federal tax returns. Lost wages, if taxable, are typically reported as ordinary income. Punitive damages and emotional distress not linked to physical injury are generally reported on Schedule 1 (Form 1040). Capital gains from property damage exceeding basis would be reported on Schedule D.

Individuals receiving a large taxable settlement should consider making estimated tax payments to the IRS. This helps avoid potential underpayment penalties, as these lump-sum payments are generally not subject to income tax withholding. Estimated taxes are typically paid quarterly using Form 1040-ES. It is advisable to consult with a tax professional for complex situations to ensure accurate reporting and compliance with tax obligations.