The Assumption That Gets People in Trouble
Many people who receive a legal settlement assume the money isn’t taxable because it came from a lawsuit — not a paycheck. That assumption can lead to a nasty surprise come tax season, or even IRS penalties for underpayment.
The taxability of a settlement depends heavily on what the settlement compensates for — not simply on the fact that it came from litigation.
What’s Generally Tax-Free
Compensatory damages for physical injuries or physical sickness are generally excluded from gross income under IRS code. This includes payment for medical bills, lost wages due to physical injury, and pain and suffering directly related to a physical injury.
The key word is “physical.” If you slipped and fell, broke your leg, and settled for $80,000 covering medical bills and lost wages, that settlement is typically not taxable.
What’s Generally Taxable
Emotional distress damages not connected to a physical injury are usually taxable. Lost wages or lost profits included in a settlement are taxable (since those wages would have been taxable income anyway). Punitive damages are almost always taxable, regardless of the case type.
Settlements from employment discrimination, wrongful termination, and harassment cases are often at least partially taxable — particularly the portions attributable to back pay or lost wages.
Attorney Fees Can Complicate Things
In many types of non-physical-injury cases, you may owe taxes on the gross settlement amount — even the portion your attorney takes as their fee. This is an area where tax law can feel deeply unfair: you receive $100,000 but your attorney takes $40,000, yet you may owe taxes on the full $100,000.
There are exceptions for certain employment and civil rights cases where attorney fee deductions are allowed, but the rules are technical. Consult both a tax attorney and a CPA before filing after any significant settlement.
The Bottom Line
Never assume a settlement is tax-free. Ask your attorney at the time of settlement how the proceeds are being categorized, and get that characterization in writing if possible — it matters to the IRS. Consult a CPA who handles litigation recoveries before you file your return.