Are Legal Settlements Taxable?

February 24, 2023 by Carolyn Richardson, EA, MBA
Settlement written on a piece of paper placed of $100 bills

Those late-night TV ads from dozens of law firms can sound so tempting if you have been injured in a car crash or felt that your employer fired you for no reason. There are firms around the country that specialize in injuries from car crashes, wrongful termination, exposure to certain chemicals, and possibly one for just existing (kidding!). If you’ve ever had to be involved in a lawsuit, either as the plaintiff or as a defendant, you know it can be a long and arduous process, with most cases resulting in a settlement of some sort. And once you receive that money, that may be the beginning of a whole new set of problems because of the tax implications of a large lump sum. We see a lot of IRS questions regarding legal settlements here at TaxAudit, usually because the taxpayer assumes it is not taxable. Sometimes, it’s what their attorney told them, but others simply assume that the settlement money isn’t taxable. While some settlements can be excluded, either in full or partially, the vast majority of legal settlements will be considered to be taxable income. Settlement income is usually reported to you on Form 1099-MISC.
 

So, is your settlement taxable?


The tax law only exempts from taxation a legal settlement received on account of physical injuries or physical sickness. It doesn’t matter if the money is received as a lump sum or as periodic (i.e., monthly) payments, as long as the underlying cause for receipt of the money is for damages resulting from a physical injury or sickness. However, punitive damages received because of a physical injury or sickness are not excludable from income. For example, you are shopping and while at the store, a display collapses, resulting in injuries to that put you into the hospital for three days. You sue the store for your injuries and the suit is settled for $20,000 for your injuries, $100,000 for compensatory damages to cover time off from work and medical expenses, and $250,000 for punitive damages as the store had a history of not maintaining their display racks, which resulted in the collapse. Under the tax law, only the $20,000 received for the injury and the $100,000 of compensatory damages related to the injury could be excluded. The $250,000 of punitive damages are taxable, even though they were received because of a physical injury.

Likewise, for example, if you worked in an occupation where you were exposed to chemicals that resulted later in serious health issues, compensatory damages for those health issues would be nontaxable as resulting from a physical illness, but punitive damages received would not be.

Emotional distress, a common term used in a personal injury law, is not a physical injury or sickness, and any compensation received on account of emotional distress is taxable income. Like punitive damages, this is taxable even if the original cause of the emotional distress was a physical injury.

One thing that confuses many taxpayers (and even tax professionals) is the use of the term “personal injury,” but do not confuse a personal injury (probably taxable) with a physical injury (not taxable). In tort law, the use of “personal injury” means any harm caused to a person, either to their body, their emotions, career, or reputation, among other things. Essentially, this is one of the things that defines when a lawsuit can be pursued. A tort is a wrongful act or infringement of a right leading to civil legal liability. However, a personal injury does not need to be a physical injury, although a physical injury is a personal injury.

There is also confusion about whether a lawsuit for discrimination based on sex, race, age, marital status, ethnicity, etc. is taxable or not. While the legal fees incurred by a taxpayer in a lawsuit alleging illegal discrimination are deductible directly from the settlement, the settlement itself is taxable income. For example, if you sue your employer for age discrimination and they agree to pay you $40,000 in damages, that $40,000 is taxable income to you. If you pay your attorney 40% of the settlement on a contingency fee agreement, your attorney will receive $16,000 of that, so your taxable amount is only $24,000 on your Form 1040.

In many cases, attorney fees are paid by the defendant directly to your attorney, and the amount of the fee is not included in the Form 1099-MISC or other reporting document that is issued to you for your portion of the settlement. If that’s the case, the fees are not includable in your income and you cannot deduct them. What about the legal fees that are included in your settlement, where you must then pay the attorney yourself? If the income from the settlement is nontaxable, such as for a settlement received for a physical injury, the attorney fees are not deductible. This is because there is a general rule in the tax code (under section 265) that prohibits the deduction of expenses that produce nontaxable income. If the payor erroneously reports it to you as income, you should include it on Form 1040 but then back it out again in the same “other income” line of the return and attach an explanation. As we mentioned earlier, legal fees incurred in a discrimination lawsuit can be deducted directly against the income reportable as taxable, if the fee was included in your Form 1099-MISC. If the fee is paid directly to your attorney, it should not be included in your reporting document.

For any other situation, though, whether the fees can be deducted depends on your grounds for the lawsuit. If you are a small business owner and you sue (or are sued) in the normal course of your trade or business, then the legal fees are deductible on your Schedule C as a normal operating expense. For example, if you are the store owner in our prior example for the display collapse, fees paid to your own attorney to defend yourself from the lawsuit filed by the injured customer would be deductible, as would the amount of the legal settlement itself (if it is not compensated by insurance).

If you are an employee and sue your employer for a reason that is unrelated to discrimination, you also cannot currently deduct your legal fees. The Tax Cuts and Jobs Act of 2017 removed the deduction of employee business expenses for tax years 2018 through 2025 and suing your employer as an employee (or former employee) would only be deductible as an employee business expense. Keep in mind that many lawsuits where an employee sues an employer result in the award of back wages reported on Form W-2, which are taxed just like your other wage income.

However, even as a small business owner or as an employee, if you sue your neighbor over their barking dog being a nuisance, that is a personal lawsuit, not a business one, and the legal fees are not deductible at all. This type of legal expense would be considered to be a personal expense, and personal expenses are not deductible, even if they result in income that must be reported on your tax return.

Finally, the last thing that muddies the water of legal settlements is the settlement document itself. Since the majority of lawsuits are settled out of court, attorneys usually use a fairly generic settlement document to make an agreement between the parties. This settlement document frequently does not specify why money is changing hands or the original reason a suit was instigated in the first place. There is usually a statement that the paying party is admitting no wrongdoing and that they are released from any further liability. This may be fine when you just want to get your money and leave, but when it comes to a tax dispute with the IRS or your state tax agency later, if you omitted the income from your return, it’s unlikely to show that the income wasn’t taxable. When it comes to these types of settlements, the “origin of the claim” rules. So, if you sued originally over a physical injury, the income will be nontaxable, but any other cause of action is likely taxable. It’s important to keep copies of all the paperwork involved in your lawsuit, should the income be questioned, so that you can show the reason you filed the lawsuit.

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Carolyn Richardson, EA, MBA
Learning Content Managing Editor

 

Carolyn has been in the tax field since 1984, when she went to work at the IRS as a Revenue Agent. Carolyn taught many classes at the IRS on both tax law changes and new hire training. In 1990, she left the IRS for a position at CCH, where she was a developer on both the service bureau software and on the Prosystevm fx tax preparation software for nearly 17 years. After leaving CCH she worked at several Los Angeles-based CPA firms before starting at TaxAudit as an Audit Representative in 2009. Carolyn became the manager of the Education and Research Department in 2011, developing course materials for the company and overseeing the research requests. Currently, she is the Learning Content Managing Editor. 


 

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