Do I Have to Claim Settlement Money on My Taxes?

Whether you have to claim settlement money on your taxes depends on what the payment is replacing. Money paid for a personal physical injury or physical sickness is generally not taxable and does not go on your return. Money that stands in for something the IRS would otherwise tax, like lost wages, business profits, or interest, is taxable and has to be reported. A single settlement can contain both kinds of money, and each part is treated on its own terms.¹

Settlement Money That Is Not Taxable

Federal law excludes damages received for personal physical injuries or physical sickness from gross income, whether the money comes from a jury verdict or a private settlement. Compensation for medical expenses and pain and suffering tied to a physical injury falls inside this exclusion.²

Two situations pull money back into taxable territory. If you deducted the related medical expenses on a prior return and got a tax benefit, you have to include that portion of the settlement in income now. And if the pain and suffering does not originate from a physical injury or sickness, the exclusion does not apply.¹

Emotional distress on its own is not treated as a physical injury under current law, so damages for emotional harm are usually taxable. The portion you use to pay for actual medical care connected to that distress is not taxable, provided you have not already deducted those costs.²

Settlement Money That Is Taxable

Punitive damages are almost always taxable, even when the underlying case involved a physical injury, because they punish the defendant rather than compensate you. A narrow exception applies in certain wrongful death actions where state law allows only punitive damages.²

Other commonly taxable components of a settlement include:¹

Interest that accrued on the settlement amount while you waited to be paid
Lost wages, back pay, or front pay from an employment lawsuit
Lost business profits or income
Emotional distress damages not stemming from a physical injury, reduced by any qualifying medical costs

How to Report Taxable Settlement Money

You have to report any taxable portion of a settlement even if no tax form ever arrives. Where it goes on the return depends on what the money replaces:¹

Lost wages from an employment case go on Form 1040 as wages
Interest on the settlement is reported as interest income
Punitive damages and taxable emotional distress proceeds go on Schedule 1 as other income³

When a settlement is paid in the course of a trade or business, the payer generally has to issue an information return, usually a Form 1099-MISC, if the taxable amount is $2,000 or more. Your obligation to report the income does not depend on whether that form reaches you.⁴

Can You Deduct Your Attorney Fees

For some taxable settlements, you can deduct the legal fees you paid above the line, which reduces your adjusted gross income. This treatment is available for:⁵

Claims of unlawful discrimination
Civil rights violations
Certain whistleblower awards

For most other cases, including a typical breach of contract claim, individuals currently cannot deduct legal fees as a miscellaneous itemized deduction. Federal law has suspended those deductions for individuals indefinitely, which can leave you paying tax on the full settlement amount even though a large share went straight to your lawyer.⁶

1
IRS. IRS Publication 4345
2
Office of the Law Revision Counsel. 26 U.S.C. § 104
3
IRS. IRS FAQ: 1099-MISC Independent Contractors and Self-Employed
4
Office of the Law Revision Counsel. 26 U.S.C. § 6041
5
Office of the Law Revision Counsel. 26 U.S.C. § 62
6
Office of the Law Revision Counsel. 26 U.S.C. § 67