As of 2019, the average legal settlement was $27.4 million, according to the National Law Review. In fact, more than half of all lawsuits settled for between $5 million and $25 million.
Is that money tax-free? For the most part, the answer is no. The IRS simply won't let you collect a large amount of money without at least informing them. And in many cases, they’ll ask for a share of the proceeds as well.
Let's look at how legal settlements are reported and taxed.
How legal settlements are taxed
Taxation on settlements can vary widely. The IRS states that the money received in a lawsuit should be taxed based on its purpose.
Here’s what that means for some common types of settlements.
Back pay: Taxable as ordinary income
Say you sue for back wages from a W-2 job. That money would typically be taxed as ordinary income.
What does that mean? You'll get a W-2 for it, and income taxes and FICA taxes will both be withheld from it. For tax purposes, your settlement is pretty much like a regular paycheck.
Think of it this way: It's income that should have been paid to you in the first place. So you'll be taxed as if you had received it when you were supposed to.
Personal injury settlements: Tax-free for "physical" injuries
Proceeds from a personal injury settlement often won’t be taxed at all, but there are some exceptions.
Let's go over the details.
How were injury settlements taxed in the past?
Before 1996, all personal damages were tax-free, whether they were for physical injuries, emotional injuries, or defamation. Since then, though, the rules have changed. These days, only physical injuries and physical sickness qualify for tax-free damages.
Unfortunately, the tax code doesn't offer a precise definition of "physical." The IRS has, however, stated that "visible harm" is required.
How are emotional distress damages taxed now?
One important consequence of the changes made in 1996: Damages related to emotional distress are now taxable. (That also goes for physical symptoms stemming from emotional distress, like headaches and stomaches.)
There are some blurred lines here. If your work environment gave you migraines, would your headaches be considered a physical condition? Or would they be seen as a symptom of emotional distress inflicted by your employer?
Often, these gray areas are exactly what a lawyer will take up when they argue on a client’s behalf.
Settlements for medical expenses: Tax-free
Settlement proceeds won't be taxed if they’re earmarked for medical expenses. That’s true even if they ultimately stem from emotional injuries.
Punitive damages: Taxable
Punitive damages, which are designed to punish the defendant for harmful behavior, can be taxed. That’s the case even if you receive them in a settlement for physical injuries.
As you can see, a single case may result in some proceeds that are taxable and some that aren’t.
For example, take a car accident case where the plaintiff got injured. They might get a settlement for their physical injuries – called “compensatory damages” – and then some punitive damages on top, if the other party’s behavior warrants it.
Although the compensatory damages are tax-free, the punitive damages can be taxed.
Settlement interest: Taxable
Settlement interest is just interest that accrues on an unpaid settlement.
You might see both pre-judgment interest, which accrues between the time of the injury and the judgment. There's also post-judgment interest, which accrues between the judgment and the time the settlement is actually paid.
Both types are taxable for the recipient.
How legal fees impact settlement taxation
These days, the attorney who represents you might take up to 40% of the settlement payment as a legal fee. (Arrangements like this, where the lawyer or law firm takes a fixed percentage of your settlement, are called "contingent fees".)
What does that mean for your taxes? Unfortunately, you'll get taxed on the full amount of the settlement — not just the 60% you got to keep. Of course, that only applies if your settlement is taxable in the first place.
To see how lawyers’ fees actually impact settlement taxation, let’s take a look at some examples.
For tax-free settlements
If your case is entirely based on physical injuries — for instance, from a car accident — then your legal settlement won't be taxed at all, no matter what your lawyer's fees amounted to.
For taxable settlements
If your settlement is taxable, it’s a different story.
Let's say you're awarded a $100,000 legal settlement for infliction of emotional distress, and your attorney has a 40% contingency fee. You'll pay your attorney $40,000 and keep $60,000.
Here's the sticking point: You'll have to report the full settlement of $100,000 to the IRS, even though $40,000 goes directly to your lawyer.
You read that right. You’re taxed on the gross settlement – not the net settlement.
Deductions for attorney fees related to legal settlements
Having to pay taxes on your lawyer’s portion of your settlement can lead to a pretty high bill from the IRS. Luckily, there are ways to lower that cost.
If your lawsuit involves your business, freelance work, or independent contracting, you'd be able to write off any attorneys' fees as a business expense.
To make sure you're deducting your legal fees correctly, consider using Keeper. The app uses software — operated by a team of human tax assistants— to handle your business write-offs and make sure you're staying on the straight and narrow.
There are other possibilities for deducting legal fees. If you’re involved in a lawsuit as a whistleblower, for example, you might also be able to deduct fees for legal services.
Why settlement agreements should specify how settlements are taxed
Because different types of settlements are taxed differently, your settlement agreement should designate how the proceeds should be taxed: as wages, injury damages, attorneys' fees, and so on.
Why? If the settlement agreement specifies how each portion of the legal proceeds is taxed, that leaves less room for disagreement once the signatures have dried.
Keep in mind: These agreements aren't binding for the IRS, but it won't ignore them either. And if the settlement agreement doesn't specify how the proceeds should be taxed, the IRS is free to make that determination by itself.
How 1099-MISCs for legal settlements work
If you receive a taxable court settlement, you might receive Form 1099-MISC.
This form is used to report all kinds of miscellaneous income: royalty payments, fishing boat proceeds, and, of course, legal settlements.
Your settlement income would be reported in box 3, for "other income."
When you'd get a 1099-MISC for a legal settlement
The IRS requires the payer to send the recipient a 1099-MISC, as long as the settlement meets the following conditions:
- The payee received more than $600 in a calendar year
- The settlement money is taxable in the first place
If your legal settlement represents tax-free proceeds, like for physical injury, then you won't get a 1099: that money isn't taxable.
There is one exception for taxable settlements too. If all or part of your settlement was for back wages from a W-2 job, then you wouldn't get a 1099-MISC for that portion. Like we mentioned before, that money would be reported on a W-2 instead.
Other tax forms for legal settlements
Keep in mind: A person might end up with multiple IRS forms for the same legal settlement.
Say someone receives a single settlement, with portions representing:
- Damages for emotional distress
- Lost wages
- Settlement interest
- Attorneys' fees
They’d get a 1099-MISC for the emotional distress damages. But on top of that, they’d get:
- A W-2 for the lost wages
- Another type of 1099, called a 1099-INT, for the settlement interest
And since their law firm got paid out of their settlement proceeds, the firm would receive a 1099-NEC for their share.
Are legal settlements tax-deductible for defendants?
Up till now, we’ve been discussing legal settlements from a plaintiff’s perspective: what they’re taxed on, and what forms the proceeds will be reported on.
Now, let’s talk briefly about the tax issues for defendants. Can those settlement payments be deducted from a payor’s taxes?
In general, lawsuit settlements are deductible if they’re incurred over the course of business.
As a general rule, these types of settlement payments are tax-deductible.
- Punitive damages
- Wrongful death
- Emotional distress
- Settlement interest
A quick note here: Punitive damages paid to a plaintiff might be deductible, but fines paid to the government aren't.
Settlements for sexual harassment: Not tax-deductible in a confidential case
In cases that involve sexual harassment or abuse, special restrictions come into play.
If the settlement is subject to a nondisclosure agreement, the defendant can't deduct their settlement payment — or their attorney fees, for that matter. That’s been the case since the Tax Cuts and Jobs Act of 2017.
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At Keeper, we’re on a mission to help people overcome the complexity of taxes. We’ve provided this information for educational purposes, and it does not constitute tax, legal, or accounting advice. If you would like a tax expert to clarify it for you, feel free to sign up for Keeper. You may also email email@example.com with your questions.