If you receive money from a lawsuit judgment or settlement, do you have to pay taxes on that money? Under Internal Revenue Code (IRC) Section 61, the IRS stipulates that all income received is taxable, unless specifically excluded from gross income. Both settlements and judgments are taxed according to the “origin” of your claim, so to speak.

First things first....settlement vs. judgment

A settlement is a voluntary agreement between an injured party (injuries can be physical, emotional, or economic in nature) and the defendant (often through the defendant’s insurance company) to resolve a case in return for a certain amount of money. A judgment, on the other hand, is what the court orders the defendant to pay after a jury or judge makes a verdict. The same tax rules apply to both settlements and judgments.

Personal injury lawsuits

• Damages from a physical injury are not taxable—it does not matter if you are paid with a lump sum or in installments.
• An award of punitive damages from a personal injury lawsuit is taxable. Punitive damages are awarded to victims in cases of serious or malicious wrongdoing. They are intended not to compensate you for your loss, but rather to punish the defendant and deter others from committing a similar offense.

Damages from emotional distress

Damages from emotional distress do not count as physical injuries under the Code, and are therefore taxable. There are some exceptions, however. Any damages you receive for emotional distress that was caused by a sickness or physical injury are free from tax. This includes situations like emotional distress resulting from car accident injuries.

This stipulation in the tax code gets difficult in cases of emotional distress resulting from a non-physical injury, like employment discrimination, for example. Under the code, damages for this type of distress are still taxable.

Non-personal injury lawsuits

For a claim not involving personal injury, any settlement you receive is typically taxable as ordinary income.

What counts as ordinary income?

• Interest on any settlement
• Most payments for lost wages/profits
• Settlements of pension rights (in event of divorce)
• Punitive damages (except in certain wrongful death cases)
• Awards for employment discrimination
• Awards for injury to reputation
• Damages for Title VII (Civil Rights Act)

Can you deduct attorney fees?

If your damages are taxable, you are permitted to deduct any attorney fees. If it’s a personal lawsuit, it would be a personal miscellaneous itemized deduction, whereas a business lawsuit would be a business deduction.

Let’s say you sue your ex-spouse for emotional distress for $200,000. You win the case, but the attorney keeps 40%, leaving you with $120,000. Though it would seem appropriate to claim only the $120,000 on your taxes, you must claim the entire $200,000 per IRS requirements, and then an $80,000 miscellaneous itemized deduction (attorney’s fees).

Questions on the taxation of legal settlements? Contact any member of our Tax Services Team.