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Taxation

Are legal settlements subject to taxation?

Short answer: It depends

The amount of money that you have to pay in taxes after receiving a legal settlement depends on the facts and circumstances of your case.[1] Your recovery may include different kinds of damages.

  • Actual damages – compensates for a proven injury or loss[2]
  • Emotional distress damages – compensates for the mental reaction directly related to the physical injury or physical sickness[3]
  • Punitive damages – intended to punish, awarded when the defendant acted with recklessness, malice or deceit[4]

Actual damages from physical injury or illness are NOT taxed. In fact when you go to file your taxes with the IRS, Title 26 U.S. Code §104 protects “damages received on account of personal physical injury or physical sickness.”[5]

Emotional distress includes physical symptoms such as headaches, insomnia, and stomach disorders.[6] The proceeds you receive for emotional distress or mental anguish originating from a personal physical injury or physical sickness are treated the same as proceeds received for personal physical injuries.[7] If the emotional distress is not a direct result of the injury, those damages must be included in income.[8]

Medical expenses are NOT taxed. They must be a direct result of the physical injury or physical sickness.[9] Keep in mind, any expenses deducted from one year’s taxes may not be exempt from taxation under a settlement that disburses in subsequent years.[10] The best thing to do is to seek tax advice as early as possible from a trusted accountant or financial advisor.

Punitive damages are TAXED in most cases, even if they relate to a physical injury or physical sickness.[11] Punitive damages are meant to punish the opposing party for his reckless behavior, and they are awarded above and beyond actual costs, medical bills, emotional distress damages, or property repair costs.[12] They should be reported as “other income” on Form 1040.[13]

Interest on any award is taxed.[14] It is considered “interest income” and should be reported on Form 1040.[15]

Compensation for lost wages and lost profits is taxed in most cases.[16] See a personal injury and tax professional to determine your exact tax liability on lost wages.



[1] I.R.S. Publ’n 4345, ¶ 1 (Rev. 11-2011).

[2] Black’s Law Dictionary (9th ed. 2009).

[3] Id.

[4] Id.

[5] 26 U.S.C. § 104(a)(2) (2014).

[6] I.R.S. Publ’n 525, 29 (Dec. 31, 2013).

[7] I.R.S. Publ’n 4345, supra note 1, at ¶ 5.

[8] Id. at ¶ 6.

[9] I.R.S. Publ’n 525, supra note 6, at 29.

[10] I.R.S. Publ’n 4345, supra note 1, at ¶ 4.

[11] I.R.S. Publ’n 525, supra note 6, at 29.

[12] Black’s Law Dictionary, supra note 2.

[13] I.R.S. Publ’n 4345, supra note 1, at ¶ 12.

[14] I.R.S. Publ’n 525, supra note 6, at 29.

[15] I.R.S. Publ’n 4345, supra note 1, at ¶ 11.

[16] I.R.S. Publ’n 525, supra note 6, at 29.