How Are Lawsuit Settlements Taxed?

By: Debra Ronca  | 

lawsuit settlement
If you receive money from a lawsuit judgment or settlement, you may have to pay taxes on that money. jamesbenet/Getty Images

After months — or even years — of courtrooms and attorneys, you finally settle your lawsuit. The money you deserve is finally coming your way. But don't start celebrating just yet, because you may have forgotten one invitee to the party: the IRS.

If you receive money from a lawsuit judgment or settlement, you may have to pay taxes on that money. It depends on the circumstances of the lawsuit and, as is typically the case with taxes, can be confusing to sort out. Here are the general guidelines. (Note: You should always consult with a tax professional when you receive large amounts of money.)

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After you collect a settlement, the IRS typically regards that money as income, and taxes it accordingly. However, every rule has exceptions. The IRS generally does not tax award settlements for personal injury cases. This means your injuries must be physical in nature. The IRS calls it "observable bodily harm," and states your injuries should be visible for your award to be tax-free [source: Wood].

You may or may not be taxed for settlements on cases that compensate you for emotional distress. Emotional distress on its own isn't a physical injury, and a lawsuit settlement for emotional distress would be taxed as income. However, if you sought medical attention for emotional distress, such as sessions with a counselor, those sessions may be tax-free. Also if your emotional distress arose from your physical injuries, you may not have to pay taxes on it. With nonpersonal injury awards, the IRS does tax the money as income.

However, there are some settlements that are more straightforward and therefore almost always taxable [source: Lawyers.com]:

  • Interest on monetary awards
  • Most punitive damages
  • Most payments for lost wages or lost profits
  • Damages for emotional distress
  • Damages for Title VII (Civil Rights Act) cases
  • Damages for patent or copyright infringement or breach of contract
  • Money received for settlement of pension rights
  • Attorney fees and costs if they are awarded as part of the settlement

For example, if you sue a competing business and receive a settlement for lost profits, that settlement is taxed as income. If your employer fires you and you sue and win for discrimination, your back wages are taxed as income. In lawsuit cases such as shoddy building repair, however, your settlement would be reported as a reduction in the purchase price of your home.

Be aware of your attorney fees as well. For example, if you sue your ex-spouse for emotional distress for $200,000 and win and your attorney keeps $80,000 as her fee, you end up with $120,000. It would seem logical to claim $120,000 on your taxes as income. However, the IRS requires you claim the entire $200,000. And since the tax law changes of 2017 and 2018, you can no longer claim the $80,000 as an itemized deduction for legal fees [sources: Wood and Wood].

The bottom line is that the IRS taxes most money you win in a lawsuit as income. If you're involved in a lawsuit, experts recommend you work with your accountant and attorney beforehand to ensure you don't run into any problems with Uncle Sam.

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Originally Published: Nov 12, 2014

Lawsuit Settlement FAQ

What is a lawsuit settlement?
A lawsuit settlement is an agreement between a defendant and plaintiff to resolve a lawsuit. One party forgoes its ability to sue in exchange for payment or another kind of compensation. It tends to happen before court proceedings.
How long does a settlement?
The settlement period is subjective and varies from case to case. However, on average, lawsuit settlements require up to six weeks to fully complete.
How is a settlement payment paid out?
Payments for lawsuit settlements are paid out in either one full payment or in series of payments as agreed upon in the legally binding contract. However, structured settlements are provided as future periodic cash payments rather than as a lump sum payment.
Is settlement money taxed?
Generally, money received as part of a lawsuit settlement is considered income by the IRS, which means it is taxable. However, money obtained in personal injury settlements, such as a car accident, is non-taxable.
Is emotional harm considered personal injury?
Emotional harm such as torture or mental distress is not considered a personal injury for tax-free settlement. The IRS states that injuries should be physical and observable for your settlement to remain tax-free.

Lots More Information

Related Articles

  • Lawyers.com. "Tax Consequences of a Legal Settlement." 2014. (Sept. 27, 2014) http://taxation.lawyers.com/tax-consequences-of-a-legal-settlement.html
  • Wood, Robert W. "5 Key IRS Rules on How Settlements are Taxed." Forbes. July 1, 2019. (Feb. 21, 2020) https://www.forbes.com/sites/robertwood/2019/07/01/five-key-irs-rules-how-lawsuit-settlements-are-taxed/#61053f544db0
  • Wood, Robert W. "IRS Gets A Share Of Most Legal Settlements." Forbes. Oct. 1, 2012. (Sept. 27, 2014) http://www.forbes.com/sites/robertwood/2012/10/01/irs-gets-a-share-of-most-legal-settlements/
  • Wood, Robert W. "New Tax on Lawsuit Settlements – Legal Fees Can't Be Deducted." Forbes. March 12, 2018. (Jan. 13, 2021) https://www.forbes.com/sites/robertwood/2018/03/12/new-tax-on-lawsuit-settlements-legal-fees-cant-be-deducted/?sh=601a80b970d7

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