Tax Rules for Lawsuit Settlements and Damages

Receiving money from a lawsuit or settlement does not always mean you have to pay taxes on it. Whether your settlement is taxable depends largely on why you received the money.

Physical Injuries vs. Emotional Distress

In general, money you receive because of a physical injury or physical illness is not taxable. However, compensation for emotional distress is generally taxable, with a couple of exceptions. For example, if your emotional distress or mental anguish is directly related to a physical injury, those amounts may be excluded from your taxable income. Reimbursements for medical expenses related to emotional trauma may also qualify for tax-free treatment in certain situations.

What About Attorney Fees?

One important thing to understand is that if your settlement is taxable, you may be taxed on the entire settlement amount, even if your attorney takes a portion of it. For example, let's say you receive a $125,000 settlement and your attorney takes $37,500 in legal fees. You would receive $87,500, but you may still have to report the full $125,000 as taxable income. Unfortunately, attorney fees are not always deductible. There are some exceptions depending on the circumstances of the case. For instance, if the legal matter was related to your business, you may be able to deduct qualifying attorney fees as a business expense. There are also special tax rules that may allow plaintiffs involved in certain unlawful discrimination claims to deduct their legal expenses.

The Bottom Line

Before assuming your settlement is tax-free, it's important to determine what the settlement was actually intended to compensate you for. The type of claim, how the settlement is structured, and the expenses associated with the case can all affect how the money is treated for tax purposes. If you receive a settlement or legal award, it's a good idea to speak with a tax professional before filing your return so you understand what needs to be reported and what deductions or exclusions may apply.