Tax Treatment of Legal Settlements and Judgements for Individuals

If you’re involved in a lawsuit or a court case (except as a juror), you may want to get up to speed on how court settlements and judgements are taxed.

Settlements and judgements are taxed the same—if you win a judgement or settle a case, the same tax rules apply.  In most cases, the IRS will consider the settlement/judgement as taxable income, unless it falls within certain guidelines.

  1. If you successfully win or settle a claim for loss of business profits/income/wages, the amount will be taxed as ordinary income.  If you were an employee, your former employer will most likely issue a paycheck with taxes withheld and generate a W-2 at the end of the year.  If you were an independent contractor, you could expect to receive the full amount of the settlement up front with no taxes withheld, but be issued a 1099-MISC at the end of the year.
  2. Physical injury damages are tax free, but personal damages (emotional distress, defamation, sexual harassment) are taxed. The IRS says that your injuries must be visible to be tax free!
  3. Payments received for medical expenses are tax-free, even if your injuries were emotional.
  4. Punitive damages and interest are always taxable. In situations such as an auto accident, part of your award may be punitive damages as well as compensatory damages for a physical injury.  While the compensatory damages for the physical injury will be tax free, the punitive damages will be taxable as ordinary income.
  5. If your recovery is taxable, there’s a good chance you’ll be paying taxes on the portion of your award that goes toward paying your attorney fees. For tax purposes, you will be treated as receiving 100 percent of the money recovered, even if the other party pays your attorney’s fees.  Since the Tax Cuts and Jobs Act repealed the miscellaneous itemized deduction category, attorney’s fees are no longer deductible on a Schedule A.

Keep in mind that your settlement or judgement may involve multiple issues with different tax treatment.  It’s best to have your disposition agreement clearly indicate what amount is allocated to each specific issue and, if possible, indicate how it should be treated at tax time.

If you’ve received a settlement or judgement, be sure to send us your agreement so we can help you classify it properly on your tax return.