Are Lawsuit Settlements Taxable?

Taxation and Deductibility of Lawsuit Settlements and Legal Fees

Some lawsuit settlements are tax-exempt, but others can come with a significant tax bill. If you receive a legal settlement, you need to understand the tax rules so that you're prepared for any tax liabilities. To reduce your tax as much as possible, you also need to know when attorney's fees are deductible. 

This guide provides an overview of the tax rules on lawsuit settlements, and then, it outlines your options if you've recently incurred an unexpected tax liability due to a settlement. 

Key Takeaways

• Not All Settlements Are Tax-Exempt: Physical injury settlements are tax-free most of the time, but non-physical injury and punitive damages are taxable.
• Taxes Vary by Settlement Type: Emotional distress, lost wages, and discrimination settlements generally are taxable as income, while interest on settlements is always taxable.
• Legal Fee Deductions Are Limited: Employment and whistleblower legal fees may be deductible, but most other fees are not deductible under the current tax code. 
• Deduction Limits on Businesses: Settlements related to business activities may be deductible, but fines, penalties, and certain harassment-related costs are not deductible.
• Plan Ahead to Avoid Surprises: Structuring settlements carefully and consulting a tax pro can help minimize tax liabiles and ensure compliance.

Tax-Exempt Legal Settlements

Settlements related to physical injuries or sicknesses are usually tax-exempt. You do not have to report these settlements on your tax return. For example, you slip and fall in a hotel and you win a settlement based on your injury. The settlement is typically not taxable and does not need to be reported on your tax return.

However, the situation can be complicated if you itemize medical expenses related to the physical injury. The rules also vary when non-physical injuries or other types of settlements are involved. Keep reading for more details. 

Taxation of Damages for Non-Physical Injuries

Damages received for non-physical injuries such as damages for emotional distress, defamation, and humiliation should be included in income. These settlements face income tax but not employment tax (Social Security and Medicare). 

But there are some exceptions. In particular, the settlement is not taxable if the emotional distress is a result of a physical injury. On the other hand, if the physical injury stems from emotional distress, the settlement is taxable. 

To give you an example, imagine that someone experiences emotional distress that leads to insomnia, headaches, or stomach ulcers and part of their settlement is compensation for these issues. That part of the settlement is taxable. But if they're making a claim for physical damages and they also receive compensation for emotional distress related to those damages, the settlement should not be taxable.

As you can see, this is a relatively convoluted issue and subject to interpretation. Ideally, you should structure the settlement so that the taxation is clear. The IRS tends to honor the intent of the parties. So, if it's clear that the settlement is for emotional damages stemming from a physical injury, it should be excluded from gross income. If it's clear that the settlement is for physical injuries that arose from emotional distress, the damages should be taxable.

Taxation of Punitive Damages

You must include punitive damages in your income regardless of whether or not they're related to physical damages. For instance, if you receive a settlement of $100,000 for compensation for physical damages and $150,000 for punitive damages, you do not have to include the $100,000 in your income, but you do have to report the $150,000 as income. 

However, if you receive punitive damages due to a wrongful death claim in a state that only allows punitive damages in these cases, you can exclude those damages from your income. 

Taxation of Employment-Related Settlements

Worker's compensation settlements must be reported as wages. If you receive back pay and damages for emotional distress related to a claim for disparate treatment, those amounts are also taxed as wages. 

Damages received to compensate you for economic losses such as lost wages or business income must be included in gross income unless personal physical injury caused the loss. 

For instance, say you received damages for lost wages because you were unable to work due to emotional distress, that part of the settlement is probably taxable. However, if you were unable to work due to physical injuries after a car accident, the portion of the settlement related to lost wages is usually not taxable. 

Taxation of Settlements From Discrimination Suits

Settlements received from age, race, gender, religion, or disability discrimination suits are not excludable from tax. You must report these settlements in your gross wages. Dismissal pay, severance pay, or other payments for involuntary termination are taxed as wages, meaning they incur income tax and employment taxes. 

Interest on Settlements

If you receive any interest on the settlement, the interest is taxable. For instance, if you're awarded a settlement but it isn't paid immediately, the payer may have to pay you interest. Even if the settlement is not taxable, the interest is. 

1099-Misc for Lawsuit Settlements

Typically, if the lawsuit settlement is taxable, the payer will issue a 1099-MISC. Some settlements are partially taxable and partially exempt. So, you may receive a 1099-MISC that only notes part of a settlement. 

If the settlement includes wages or back pay, you may receive a W2. Settlements reported on W2 forms face both income tax and employment tax. 

Payers may also issue 1099-Misc forms when they send out attorney payments. If the payer is issuing an award that is taxable to the plaintiff, they should issue a separate 1099 when sending payment to the attorney. 

Example of Tax on Lawsuit Settlements

Here's an example of how a lawsuit settlement might be taxed. Imagine that a jury awards a plaintiff $50,000 for lost wages, $100,000 for emotional distress, and $25,000 as punitive damages. All of these settlements are taxable. When the plaintiff receives the settlement, they include the $175,000 on their tax return. 

Note that most of these amounts are only subject to income tax, but the $50,000 for lost wages is also subject to Medicare and Social Security taxes. The plaintiff also paid a lawyer $50,000 to represent them. So, they deduct $50,000 from the settlement amount, bringing their taxable settlement down to $125,000. 

At the same time, the attorney must include the $50,000 they received as income on their tax return. However, because it's business income, the attorney can deduct business expenses from that amount just as they do from the rest of their business income. 

Are Legal Fees Deductible?

In the above example, the plaintiff deducted the legal fees. Legal fees for employment and whistleblower claims are an above-the-line deduction — that means they're claimed on the first page of your tax return, and they directly reduce the taxable portion of the settlement as described above. In 2021, the IRS added a line for this deduction to its 1040 Form, making it easier for tax preparers and individuals to navigate.

In the past, legal fees for other settlements could be deducted below the line — which means that they were deductible if you itemized and the expenses met other relevant rules. However, the Tax Cuts and Jobs Act removed the below-the-line deduction for settlement legal fees from 2018 to 2025. 

As a result, some plaintiffs face taxes on the entire amount of their settlement, regardless of how much they paid in legal fees. To avoid an overly high tax liability, you should consult with a tax professional. 

Are Legal Settlements Deductible for Defendants?

But what about the defendant who paid the settlement? What are their tax consequences? If they're paying a settlement personally, they cannot claim any deductions on their tax return, but if they're paying the settlement from their business, they may be able to claim a deduction.

Are Legal Settlements Deductible for Businesses?

Businesses may be able to deduct some settlements but not others. First of all, to be deductible, the settlement must be related to business activities. For instance, a business may not be able to deduct the cost of a settlement that arose from an incident that happened while the business owner and employees were on a social vacation together. However, if the same incident happened while they were at a work conference, the settlement may be deductible. 

The nature of the settlement also affects its deductibility. Fines, punitive, and penal damages are not deductible. But the business may be able to write off the legal costs associated with those cases as business expenses. 

However, businesses cannot write off legal expenses related to sexual harassment cases with non-disclosure agreements. Presumably, this law was designed to punish businesses with a lot of sexual harassment cases, but its broad wording also created a situation where plaintiffs can no longer deduct legal fees related to these cases. 

How to Prepare for Legal Settlement Taxes

The best course of action is to address the taxation of the legal settlement before the settlement is paid. Make sure that the legal documents clearly reflect the intent of both parties in relation to taxation. If you're receiving a taxable settlement, be aware of your tax liability and make plans to pay it. 

What to Do If You Owe Taxes Due to a Legal Settlement

However, many people only become aware that their settlement is taxable after they receive it. If your settlement was taxed as wages, you may be facing the 7.65% Social Security and Medicare tax plus income tax. Even if your settlement only faces income tax, the rate can be anywhere from 10 to 37%, depending on your income bracket. 

If the IRS assesses a tax liability due to a legal settlement, you can pay the tax bill in full, or you can explore these options: 

• Appeal — if you don't believe that the settlement should be taxable, you have the right to appeal the assessment. Appeals must be handled in a specific way on a certain timeline. 
• Request a payment plan — The IRS allows most taxpayers to make monthly payments on unpaid tax liabilities. 
• Apply for an offer in compromise — If you don't have enough income or assets to pay the tax liability from a legal settlement, the IRS may be willing to compromise and settle for less than you owe. 
• Ask for hardship status — If you cannot afford to pay the tax, the IRS may temporarily stop collection actions on your account.

Get Help With Taxes on Legal Settlements

Have questions about a legal settlement? Want to know if you can deduct fees or costs related to a settlement? Need help dealing with an unexpected tax liability due to a legal settlement? Then, you need a qualified local tax professional to help you. 

At TaxCure, our directory of tax professionals makes it easy to find qualified and experienced tax professionals in your area. Have unpaid taxes due to a settlement and can’t pay? Start a search by clicking the “Find a Local Pro” button to search for a tax professional near you that can help.