The taxation of structured settlements turns on one question: what was the underlying claim? Payments for personal physical injuries or physical sickness are entirely free from federal income tax under Section 104(a)(2) of the Internal Revenue Code, including the investment growth inside the annuity that funds them.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness Payments tied to punitive damages, employment claims, defamation, or standalone emotional distress are taxable as ordinary income, and structuring the money as periodic payments does not change that.
Payments That Arrive Tax-Free
Section 104(a)(2) excludes damages received on account of personal physical injuries or physical sickness, whether the money arrives as a lump sum or as periodic payments through a structured settlement. The exclusion covers every compensatory element tied to the injury: medical bills, lost earnings, pain and suffering, and loss of consortium. Each payment lands tax-free for the full life of the settlement.
Workers’ compensation benefits get the same treatment under a separate provision, Section 104(a)(1), which excludes amounts received under workers’ compensation acts as compensation for personal injuries or sickness.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness A workers’ comp claim resolved through a structured annuity qualifies for the same tax-free periodic payments as a tort claim.
The exclusion reaches further than many recipients expect. In an ordinary investment account, interest and gains are taxed as they accrue or when distributed. In a properly structured settlement, the annuity grows without any tax consequences to the recipient because the recipient never owns or controls the annuity. The defendant or an assignment company holds the policy; the recipient simply receives payments as they come due. That tax-free compounding is one of the core financial reasons to choose periodic payments over an upfront lump sum.
Payments That Are Fully Taxable
The Section 104(a)(2) exclusion draws a hard line at physical injury and physical sickness. Everything else is generally ordinary income, reported on Schedule 1 of Form 1040.2Internal Revenue Service. Publication 4345 – Settlements Taxability
Punitive Damages
Punitive damages are taxable even when they come out of a case involving real physical injury. The statute explicitly carves them out of the exclusion.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness A narrow exception under Section 104(c) applies in certain wrongful death actions where state law permits only punitive damages as the available remedy.3Internal Revenue Service. Tax Implications of Settlements and Judgments
Non-Physical Injury Claims
Settlements for employment discrimination, defamation, breach of contract, invasion of privacy, and similar claims are fully taxable. The harm may be genuine, but if it isn’t physical, the exclusion doesn’t apply. Structuring an employment discrimination recovery as periodic payments spreads the taxable income over multiple years, which can help with bracket management, but it grants no exclusion.
Emotional Distress
Emotional distress sits in an awkward middle ground. The statute says explicitly that emotional distress is not treated as a physical injury or physical sickness, so damages for a standalone emotional distress claim are taxable. Two exceptions apply. If the emotional distress flows directly from a physical injury, such as anxiety caused by a spinal cord injury, those damages share the physical injury’s tax-free status. And amounts paid for medical care attributable to emotional distress, including therapy, psychiatric treatment, or medication, escape taxation up to what you actually spend on that care.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness
Why the Settlement Agreement Wording Controls
The document that resolves the claim is the primary tax document. If it allocates damages cleanly between physical injury (tax-free) and other components (taxable), the IRS generally follows that allocation. If the language is vague, the IRS looks past the labels to the nature of the underlying claim and can challenge the exclusion outright.
Two structural rules also have to hold, or the exclusion collapses. First, most structured settlements use a “qualified assignment” under Section 130, in which the defendant or insurer transfers the payment obligation to an assignment company that funds an annuity. The payments must be fixed in advance as to amount and timing, and the recipient cannot have any power to accelerate, defer, increase, or decrease them.4Office of the Law Revision Counsel. 26 USC 130 – Certain Personal Injury Liability Assignments Any recipient control over the payment stream can unravel the arrangement.
Second, the doctrine of constructive receipt. Income is constructively received when it’s credited to your account, set apart for you, or otherwise made available so you could draw on it, even if you don’t.5eCFR. 26 CFR 1.451-2 – Constructive Receipt of Income A claimant who negotiates for a lump sum and only later decides to put part of it into a structure is treated as having received the whole amount at once, taxable in that year. The decision to structure has to be baked into the settlement agreement from the start, with the claimant entitled only to periodic payments and no right to demand the underlying principal.
Attorney Fees on Taxable Settlements
On a tax-free physical injury settlement, the lawyer’s contingency fee comes out of money that was never taxable. Nothing to report.
On a taxable settlement, the math turns painful. Under the assignment of income doctrine, the IRS attributes the full settlement amount to the recipient, including the portion paid directly to the attorney under a contingency agreement. Win a $500,000 employment discrimination settlement, pay your lawyer 33%, and you report $500,000 in gross income even though $335,000 hit your account.
Before 2018, recipients could deduct those attorney fees as a miscellaneous itemized deduction. The Tax Cuts and Jobs Act suspended that deduction for 2018 through 2025, and the One Big Beautiful Bill Act of 2025 made the elimination permanent. There is no longer any path to deducting contingency fees as a miscellaneous itemized deduction on a taxable settlement, regardless of the tax year.
One meaningful exception. Section 62(a)(20) allows an above-the-line deduction for attorney fees and court costs paid in connection with claims of unlawful discrimination, defined broadly to include Title VII of the Civil Rights Act, the Age Discrimination in Employment Act, the Fair Labor Standards Act, the Americans with Disabilities Act, the National Labor Relations Act, the Family and Medical Leave Act, and several other federal statutes. Section 62(a)(21) extends the same above-the-line treatment to attorney fees in whistleblower actions, including SEC whistleblower claims and state false claims act cases.6Office of the Law Revision Counsel. 26 USC 62 – Adjusted Gross Income Defined The deduction is capped at the settlement income included, so it can’t create a loss, but it eliminates the “paying tax on money you never received” trap for qualifying claims. For taxable settlements outside those categories, the full assignment of income problem still bites and no deduction is available.
Selling Future Payments
Recipients who need cash sometimes sell their future payment rights to a factoring company for a discounted lump sum. Every state except one requires court approval before the sale can proceed, and the court has to find the transaction is in the recipient’s best interest.
Federal tax law reinforces that gatekeeping. Section 5891 imposes a 40 percent excise tax on any person who acquires structured settlement payment rights in a factoring transaction. The tax falls on the factoring company, not the recipient, and is calculated on the difference between the undiscounted value of the payments acquired and the amount actually paid to the recipient. The excise tax does not apply when the transfer is authorized by a “qualified order” from the appropriate state court, which requires findings that the transfer complies with law and serves the payee’s best interest.7Office of the Law Revision Counsel. 26 USC 5891 – Structured Settlement Factoring Transactions
For the recipient, the tax character of the lump sum follows the tax character of the original settlement. If the periodic payments were excluded under Section 104(a)(2), a court-approved sale generally preserves that tax-free treatment. If the underlying settlement was taxable, the sale proceeds are taxable too. The bigger cost of selling is usually the factoring discount itself, not the tax result.
What You Need to Report
Tax-free structured settlement payments for physical injuries generally trigger no reporting on the recipient’s return. The payments are excluded from gross income, so there’s nothing to include.
Taxable settlements are different. The payer reports the gross amount, and the recipient reports it as income. Attorney fees paid as part of a settlement flow through Form 1099-NEC or Form 1099-MISC depending on how they’re characterized.8Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC Expect those forms and make sure your return matches what was reported to the IRS. Keep a clean copy of the settlement agreement and any court orders. If a question arises later, that paperwork is what supports the tax treatment.
What Happens When the Recipient Dies
Many structured settlement annuities include a guarantee period or a beneficiary provision that continues payments after the recipient’s death. When the original settlement qualified under Section 104(a)(2), the remaining payments generally continue to be excluded from income for the beneficiary or the estate. The tax-free character attaches to the payments based on their origin as damages for physical injury, not to who is receiving them.
Because the recipient never owned the annuity, no annuity contract passes through the estate in the traditional sense; the assignment company simply keeps paying whomever the settlement agreement designates. The annuity’s value may still be counted for federal estate tax if the estate is large enough to owe it, but the income tax exclusion on the periodic payments themselves survives the recipient’s death.