Are Lawsuit Settlements Taxable?

Are lawsuit settlements taxable? Unfortunately, the best answer is: sometimes. The best way to learn how a settlement could affect you is to discuss your situation with a qualified tax professional. 

That said, if you're expecting a lawsuit settlement and you want to know if the money is taxable, there’s plenty to learn about IRS rules and reasoning for how to treat damages awarded in lawsuits. 

We’re not tax professionals. This information is intended for general educational purposes, and it’s not advice about your taxes. Please consult a qualified tax professional about your specific tax situation.

Settlements and Tax Liabilities

The IRS is mostly focused on collecting taxes on income. A settlement covering lost or reduced income is often considered taxable, because that money is replacing your taxable personal income. On the other hand, lawsuit settlement money covering current and future medical expenses is typically not taxed as income. These funds are reimbursing you for costs you have paid or expect to pay.  

How much tax do you pay on lawsuit settlements? It depends on the nature of the damages (the loss you suffered) and how your settlement is structured. You and your attorney should plan carefully when you prepare a lawsuit and accept a settlement, so you aren’t surprised by what you owe the IRS.

Let’s look at a few times when lawsuit settlements are taxable—and what it might mean for your personal finances.

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When are Lawsuit Settlements Taxable?

If you’re a plaintiff involved in a lawsuit (you sued someone), you may feel happy and relieved if the court decides in your favor or the suit is settled to your satisfaction. But you may wonder: Is a court settlement or judgment taxable? And you may be surprised to learn that many people must pay taxes after winning or resolving a lawsuit. 

According to the IRS, except in rare circumstances, all income is taxable. That generally includes income earned from a lawsuit judgment or settlement.

Here are some examples of a lawsuit settlement that may be taxable:

• Emotional distress without injury. If you’re awarded a settlement for emotional distress that does not relate to a specific injury, it is usually considered taxable.

• Lost wages. Lost wages can arise from a host of factors, including wrongful termination, discrimination claims, harassment, defamation, libel, and slander. If you receive a settlement related to an employment issue, it’s usually taxable.

• Breach of contract settlement. If you’re awarded a settlement for breach of contract, it leads to more income. That’s generally a taxable event.

• Punitive damages. Punitive damages are awarded when a person or entity acts recklessly or maliciously, causing you harm. Even when punitive damages relate to physical injury, they’re generally taxable. 

• Interest on a settlement. If your settlement includes interest, the interest portion of your payout is generally taxable.

When are Lawsuit Settlements Not Taxable?

There are some types of lawsuit settlements that follow different IRS rules. This includes car accident claims of personal injury, and work injury claims of worker’s compensation.

You don’t have to pay taxes on these three three types of lawsuit settlements: 

• Personal physical injury 

• Worker’s compensation 

• Non-disclosure agreements related to sexual impropriety. 

Are Class Action Settlements Taxable?

A class action lawsuit is a lawsuit in which a large group of people who have been harmed by the same entity are represented by a lead plaintiff (or group of lead plaintiffs). 

Class action lawsuits tend to fall into two categories:

• Compensatory class action lawsuits compensate victims for a loss they suffered, whether financial or physical. 

• Punitive class action lawsuits are not meant to compensate victims for a loss so much as punish an entity for doing something wrong.

There's no minimum number of people required for a class action lawsuit. In some cases, a few dozen people can band together to file one. In other cases, you might have thousands of people.

Some of the most common types of class action lawsuit include:

• Consumer fraud, when a company misleads consumers in its marketing or makes false claims

• Product liability, when a company produces a product that's doesn't work the way it's supposed to or causes people harm

• Securities, when a company lies about its financials

• Data breaches, when a company doesn't protect its customers' personal data

• Employment, when a company violates labor laws (such as not paying overtime).

The rules for class action lawsuits are similar to those that apply to individual lawsuits. When the settlement is related to physical injury or harm, it's generally not taxable. When the settlement is related to lost wages, breach of contract, or punitive damages, it generally is taxable.

Ultimately, the specifics of a class action lawsuit determine whether a settlement related to it is taxable. An attorney and tax professional should be able to advise you on whether you should expect to pay the IRS a portion of your settlement. 

Are Debt Settlements Taxable?  

Yes, there are often tax consequences of debt settlement. To the IRS, getting debt forgiven is the same as having someone put the money in your hands to pay it. But not everyone pays taxes on forgiven debt. Canceled debt is considered taxable income unless you’re insolvent (the value of your debts is more than the value of the things you own) at the time you settle the debt.

If you need credit card debt relief or other debt settlement help, your lenders and creditors may agree to settle your debts by accepting a smaller amount than what you owe. The IRS treats forgiven debt the same as income you receive. 

For example, if you owe $15,000 on a credit card and can’t pay your bills, you might ask the credit card company to accept $10,000 instead. If the creditor agrees to settle for $10,000, they report $5,000 of forgiven debt to the IRS. If you’re in the 12% tax bracket, you might owe $600 in federal income taxes for that debt settlement. 

If you’re insolvent when you settle the debt, you don’t have to pay federal income taxes on the forgiven debt.

Many people who pursue debt settlement are insolvent. There are countless scenarios in which your debts might exceed your assets. Here’s an example:

Charlie is solvent, so Charlie’s forgiven debt would be considered taxable income. That doesn’t mean Charlie shouldn’t pursue debt settlement, only that it’s a good idea to factor in the potential tax bill when choosing any debt strategy.

Sam is insolvent by $3,000, so the first $3,000 of forgiven debt wouldn't be taxable. Sam should assume that forgiven debt above that amount could be taxed.

You can get a sense of what the IRS is looking for by reviewing Publication 4681. It includes a worksheet to determine insolvency. Consult a tax professional who can help you make sure your worksheet is complete and correct. 

Getting a big windfall of money from a successful lawsuit or negotiating an agreement with your creditor can be a huge relief for your personal finances. But the settlement doesn’t close the book on the debt completely. Plan for the tax consequences. 

Tax Treatment by Settlement Type

When you receive a lawsuit settlement, it's natural to wonder whether you'll keep the entire sum. Here's a breakdown of how different types of settlements are usually handled. 

Personal injury settlements 

Personal injury lawsuits can run the gamut from medical malpractice to car accidents, to accidents that happen on a person's property (such as a tripping hazard that results in an injury). 

If your settlement is related to a physical injury, it is generally tax-free. However, it's possible to get a settlement for a personal injury that includes punitive damages. In that case, the punitive damages portion may be subject to taxes. 

Employment and wrongful termination settlements

Employment lawsuits can arise when employers violate labor laws. Similarly, wrongful termination lawsuits can arise when an employer fires someone for an illegal reason, such as based on their appearance, gender, race, religion, or sexual orientation. Employment and wrongful termination settlements are generally taxable. 

Emotional distress settlements 

Emotional distress lawsuits can arise when someone suffers emotional harm, even if there was no physical harm. However, emotional distress lawsuits and physical injury lawsuits often go hand-in-hand.

Emotional distress settlements are generally taxable. If there was an injury, the portion of a settlement related to the injury itself is generally not subject to taxes. On the other hand, the emotional distress portion of a settlement is.

Property damage settlements

Property damage settlements generally are not taxable if the amount you're awarded is equal to or less than the value of the property itself. For example, let's say you purchase artwork for $2,000 and pay to have it moved, only to have it destroyed in transit. You may get a settlement for $3,000 based on the market value of the artwork—but the extra $1,000 beyond its original value of $2,000 may be taxable.

Put another way, when a property damage settlement simply compensates you for lost money, it generally isn't taxable. If you're making money from the settlement, taxes can apply.

Breach of contract settlements

Breach of contract settlements are generally taxable, because you're being made whole on a loss of income. Had you earned that income per the terms of your contract, it would have been taxable. So if you're getting it as a result of a settlement, it remains taxable.

IRS Lawsuit Settlement Rules

The IRS has four basic rules that dictate the taxation of litigation settlements or judgments.

1. The origin of the claim. Settlements for physical injuries aren't subject to taxation. Emotional distress could be taxable if it didn't originate from bodily injury or sickness due to an accident.

2. Tax agreements. You and the defendant (the person you’re suing) could agree to allocate portions of a settlement to different categories of damages when some are taxable and others aren't. Such agreements aren’t binding on the IRS or the courts in later tax disputes, and could be ignored. But they’re usually honored.

3. Attorney fees. If you use a contingent-fee lawyer, all money you recover as a plaintiff could be taxed, including the contingency fee. That only applies to taxable settlements. With a physical injury case, for example, you still don’t owe taxes on what you receive. 

4. Punitive damages. Suppose you suffered injuries in a car accident. You are awarded $60,000 in compensatory damages and $6 million in punitive damages. The compensatory damages are tax-free, but the punitive damages are fully taxable.

How to Estimate Taxes on Settlement Money

A settlement could constitute a big financial win. But don't make plans for settlement money without being sure what sort of tax bill might ensue.

To see if your settlement is taxable:

• Figure out what type of settlement it is, such as compensatory versus punitive.

• Check the IRS rules regarding your settlement.

• Figure out what IRS tax bracket you fall into based on your income.

• Do the math.

Here's a basic example. But keep in mind that you may need the help of an attorney and/or tax professional to figure out what tax liability you have on your settlement.

Let's say you're awarded a $5,000 settlement that's subject to taxes, and your tax bracket is 24% based on your income. That means you may lose 24% of your settlement, or $1,200, to taxes. 

This, however, is a simplified example, because there may be other factors that change your tax obligation, and you may be able to deduct attorney fees on your taxes and minimize the blow. 

Also, while the above formula may allow you to calculate your federal tax obligation on a settlement, you might also owe state taxes, depending on where you live. 

Rules for Plaintiffs vs. Defendants

Plaintiffs aren’t the only ones who have to be concerned about paying taxes on lawsuit settlements or judgments.

If someone sues you, you might lose, or settle out of court. If you then sell some things you own in order to pay the judgment, those transactions could trigger taxes. For example, let’s say you’ve been working on a stamp collection that’s worth more than you’ve invested in it. The IRS would consider you a hobbyist because you purchased those stamps hoping they would increase in value over time. If you sell collectibles at a gain, that’s taxable income.

Taxable Attorney Fees

Regardless of whether you pay your attorney on a contingent-fee basis or by the hour, legal fees affect your tax obligations.

When there's a lawsuit settlement, the payer (the losing person or organization) makes a payment to the person who won. Sometimes the payer also has to pay the other side’s attorney. 

In that case, the payer reports the payment to you and the attorney’s fees on separate forms to the IRS. For this type of situation, you, as the winner, don’t report the attorney’s fees to the IRS. 

The tax reporting situation is slightly different if you use a contingent-fee lawyer (one who only gets paid based on winning or settling your lawsuit). If you receive an award won or recovered by a contingent-fee attorney, the entire amount is reported to the IRS, including the portion you give your attorney. This could increase your tax obligations or require a more-complicated tax return. 

Damages related to physical injury or sickness aren't taxed. But if you receive payments from other types of lawsuit settlements, it’s worth it to contact a professional accountant or tax advisor who can help you understand your tax obligations. 

Other Expenses Involved

Taxes aren’t the only things you may have to pay if you are involved in a lawsuit. You might have to pay court fees, as well as paying for any expert opinions or reports you solicit to back up your claim. 

For some people, it’s possible to deduct certain litigation costs from your taxable income in the year you paid them. Check with a tax professional for details.

When Taxes Are Due

If you owe taxes related to a lawsuit settlement or judgment, you’re expected to pay those taxes when your return is due for the tax year in which the settlement or judgment was reached.

If your tax year finishes on December 31, your tax return is usually due on April 15 of the following year.

Additionally, be aware that taxes are only withheld from the money that’s sent to you if the person paying you is legally obligated to withhold. If the withholding doesn’t happen, you’re responsible for paying the taxes yourself. When you file your taxes, you're expected to provide a plan for payment of any outstanding taxes if you can’t pay when they’re due.

Tax Reporting Requirements for Settlements

If your lawsuit settlement is taxable, you're required to report it to the IRS. If you receive a settlement, you may get a 1099-MISC form, which you include when filing your tax return. If your settlement is for lost wages, you may get a W-2 wage summary. 

It's important to keep all documentation related to your lawsuit settlement so you have the right information to file your tax return. Generally, W-2s and 1099 forms are due on Jan. 31 each year. 

The IRS recommends keeping all tax documents for three years from when you file a tax return. That’s because the IRS generally has three years to audit an old tax return or request further documentation. 

How to Avoid Taxes on Lawsuit Settlements

In some cases, it may not be possible to avoid paying taxes on a lawsuit settlement. That’s because, as discussed earlier, certain types of settlements are basically always subject to taxes.

If your settlement has taxable and non-taxable components, a good attorney should word your settlement agreement in a way that makes it clear which portion is yours tax-free. It could also be a good idea to loop in a tax professional while you're negotiating a settlement, so they can make recommendations while there’s still time to fine tune the details.

If it is clear that your claim is taxable, work closely with a tax attorney to manage the impact on your personal finances. Work with an attorney who has experience participating in settlement conferences as well as knowledge of tax rules. If you have a tax planner, loop them into the conversation as well.