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 was meant to replace. Money that compensates you for a physical injury or physical sickness is generally not taxable. Money that stands in for something the IRS would have taxed anyway — wages, business profits, interest — is taxable and has to be reported.¹

A single settlement can contain both kinds of money. The tax treatment is applied piece by piece, not to the lump sum.¹

Parts of a Settlement You Don’t Have to Claim

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 agreement.² That generally covers compensation for medical expenses and for pain and suffering tied to the physical injury.¹

One catch: if you deducted those medical expenses on a prior return and got a tax benefit from the deduction, you have to include that portion of the settlement in income the year you receive it.¹

Emotional distress on its own is not treated as a physical injury, so damages for emotional harm are usually taxable. The narrow exception: the portion of an emotional distress award used to pay for actual medical care related to that distress is not taxed, as long as you haven’t already deducted those costs.²

Parts of a Settlement You Have to Claim

Several common settlement components are taxable income:

Punitive damages, which are meant to punish the defendant rather than compensate you, are almost always taxable even when the underlying case involved a physical injury.²
Interest that accrued on the settlement amount while you waited for payment.¹
Lost wages, back pay, or front pay from an employment case.¹
Lost business profits or income.¹
Emotional distress damages that did not stem from a physical injury, less any qualifying medical costs.²

How to Report It on Your Return

Taxable settlement income has to go on your return even if no tax form arrives. Where it goes depends on what the money represents:¹

Employment-related lost wages are reported as wages on Form 1040.
Settlement interest is reported as interest income.
Punitive damages and taxable emotional distress proceeds are reported as other income on Schedule 1.

When a settlement is paid in the course of a trade or business, the payer is generally required to issue an information return — usually a Form 1099-MISC — if the taxable amount is $2,000 or more.³ Your duty to report the income does not depend on whether that form shows up.⁴

What About the Attorney’s Cut?

If your settlement income is taxable, you may be able to deduct the attorney fees paid to get it. An above-the-line deduction, which reduces your adjusted gross income, is available for cases involving:⁵

Claims of unlawful discrimination
Civil rights violations
Certain whistleblower awards

For most other claims — a typical breach of contract case, for example — individuals currently cannot deduct legal fees as a miscellaneous itemized deduction. Federal law has suspended those deductions indefinitely for individuals. That means you can end up owing tax on the full taxable settlement, including the share that 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