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Is Income from Lawsuits and Legal Settlements Taxable?

Life is unpredictable, and no matter how hard you try to resolve disputes, sometimes the only remaining course of action is a legal one. If you have ever received a legal settlement, you probably paid tax on it as a form of income. This is the case with most settlements. But there are exceptions where settlements can be exempt from taxation.

Table of contents

Key highlights...Read more

Are settlements taxable?...Read more

Taxing a settlement amount...Read more

Which legal settlements are tax-free?...Read more

IRS regulations for taxes on settlements...Read more

Key highlights

Legal settlements are taxable in most cases.
The IRS taxes legal settlements by including them as income.
There are some instances where settlements are tax exempt.

There is an exception where you may not need to pay tax when you receive a legal settlement. A legal settlement is an amount of money you (plaintiff) receive after filing a lawsuit against another person, company or group of people (defendant). The amount of money is to cover physical and emotional damages. If you file a lawsuit for loss of property then the proceeds of the settlement will help you cover those costs. A plaintiff is the party filing a lawsuit and a defendant is the party defending their side of the story.

Are settlements taxable?

According to the Internal Revenue Service (IRS), income of any kind is taxable, including settlements. There are some exceptions to this, but they are only applicable in certain situations.The IRS is more interested in what the money from the settlement is for than what the nature of the lawsuit is. For example, if you were in a car accident, and your settlement from a lawsuit went to cover your medical expenses, the IRS might exempt you from paying taxes on the settlement. This rule applies to every taxpayer whether they pay self-employment taxes and/or income tax.

Taxing a settlement amount

The IRS is a constantly evolving entity, and rules and regulations around taxes can change. For example, no legal settlements were taxed until 1996. Since then, settlements for emotional distress and defamation have been taxed but not settlements for personal damage like physical injury, or physical damage to property like a house or car.

Image shows text about IRS categorizing settlements into two groups - claims from physical and non-physical injuries. No mention of self-employment, 1099, freelancer or taxes.

When it comes to taxing settlements, the IRS classifies the settlement amounts into physical damages, emotional damages and punitive damages. Physical damages are any damage to property or person that can be quantified in terms of repairs and medical treatment. Emotional damages is any damage caused to the mental health of a person due to a dispute. Emotional damages are assessed by clinical psychologists appointed either by the court or brought in either by plaintiff or defendant upon request. Punitive damages could be awarded to either of the parties in a lawsuit, depending on the judgment. Punitive damages are intended to punish either of the two parties following legal analysis of a case.

Image describing three types of damages in a lawsuit - actual damages from injury, emotional distress from injury, and punitive damages. No relevance to self employed, 1099, freelancer, or taxes.

Which legal settlements are tax-free?

Physical damages: tax exempt

Let’s say that A accidentally sets fire to B’s house, and his clumsy act was caught on camera. Although it was an accident, this was not cool on A’s part, and B wins a lawsuit against A for $1M in damages. This amount will be completely tax-free because the entire amount will be used to repair the physical damage caused by the fire. Similarly, settlements used to cover medical expenses are tax-exempt. If X wins a lawsuit against a hospital that treated him, the settlement amount will be completely tax free. This is because X is still ill and will need additional treatment at a different hospital. Or, if a delivery driver is awarded a settlement after a car crash, it could be tax-exempt, as it will cover the costs of repairs to the driver's car.

Alt text: Image with text about tax-exempt settlements, whistle-blower cases, and legal fees of a lawsuit that helped IRS find tax violations. Relevant for taxes, self-employed, 1099, and freelancers.

Emotional damages/defamation: taxable

One of Hollywood's most high-profile cases was the 2022 Johnny Depp vs. Amber Heard lawsuit The Johnny Depp (plaintiff) vs Amber Heard (defendant) lawsuit was a defamation lawsuit. The Pirates of the Caribbean star sued Heard for $50 million in damages for her comments that hurt his reputation. The trial spanned more than two and half months, and the resulting verdict was in favor of old Johnny. The jury awarded Depp $10 million in compensatory damages and a further $5 million in punitive damages. The jury also awarded Heard $2 million in compensatory damages for false claims from Johnny Depp’s lawyer Adam Waldman that Amber’s friend vandalized his apartment. Both the amount awarded to Depp for punitive damages and the amount awarded for compensatory damages are taxable, which means Captain Jack Sparrow will be paying taxes on the settlement when or if he receives it..

Interest on settlements: taxable

If the judgment on a case is taking longer than expected, and the plaintiff is awarded interest on top of the settlement amount, that interest is taxable. There are other ways to lower your taxes, if you are a freelancer or self-employed individual – like using FlyFin A.I. to find all your possible business deductions. FlyFin also has an estimated tax calculator to help you figure out your quarterly taxes

IRS regulations for taxes on settlements

Section 104 of the IRS' legal code outlines different tax exemptions and explains that gross taxable income doesn't include amounts received for physical injuries to a person or a person’s property. But the best way to know for sure whether a settlement you receive is taxable is to talk to an expert and ask your attorney or a CPA. One last thing to consider with your settlement and the issue of taxation is lawyer’s fees. These aren't allowed to be deducted from the tax bill resulting from your settlement amount. If you were awarded $50,000 from a physical injury while you were working as an independent contractor on a construction site, you can't deduct the fees for paying your attorney, even if you are exempt from paying taxes on your settlement. In some cases, attorney fees can be 40% of the settlement amount. On the other hand, if you were awarded $150,000 in a defamation case, you’ll have to first pay taxes on this amount and then also pay your lawyers. The tax and the lawyer fee will ultimately decide the amount that you actually get.

Adjust For Inflations

The IRS has released its yearly inflation adjustment for the 2024 tax year, aimed to give US taxpayers relief from rising inflation.