Settlement Payments

Are Legal Settlements Taxable? Here’s What You Need to Know

You’ve seen the commercials—law firms promising big settlements for everything from car accidents to wrongful termination. And if you’ve ever found yourself involved in a legal dispute, you know the process can be emotionally draining, time-consuming, and often ends with a settlement. But before you celebrate that check, there’s one more hurdle to clear: taxes.

At Lisa Brugman, EA, we receive a steady stream of questions about the taxability of legal settlements, mostly because many taxpayers (understandably) assume they aren’t taxable. Sometimes it’s based on something an attorney said. Other times, it’s simply a case of wishful thinking. But here’s the truth: most legal settlements are considered taxable income.

What Kinds of Settlements Are Not Taxable?
Generally, the IRS only excludes settlements for physical injuries or physical sickness from taxation. Whether you receive the funds as a lump sum or in monthly installments, if the origin of the claim stems from physical harm or illness, that portion may be excluded from income.

However, punitive damages are always taxable, even if awarded in a personal injury case. For example: 

Let’s say you’re injured in a store when a faulty display collapses. You sue and receive: 

• $20,000 for your physical injuries (nontaxable), 

• $100,000 to compensate for lost wages and medical expenses tied to that injury (nontaxable), and 

• $250,000 in punitive damages due to the store’s negligence (taxable). 

The IRS makes a clear distinction here—punitive damages are meant to punish, not to compensate, and are therefore taxable.

What About Emotional Distress?
This is where things often get murky. Emotional distress, unless directly caused by a physical injury, is considered taxable income. Even if the emotional distress was triggered by a physical injury, only out-of-pocket medical expenses for that distress are potentially excludable—not the compensation itself.

Also worth clarifying: “personal injury” isn’t the same as “physical injury.” In legal terms, a personal injury can refer to harm done to your reputation, career, or emotions. Only physical injuries and sickness qualify for tax exclusion.

Discrimination Lawsuits and Taxation
Many taxpayers are surprised to learn that settlements for workplace discrimination—based on race, age, sex, or other protected classes—are taxable, even if they feel deeply personal. However, legal fees in these cases may be deductible.

Let’s break it down:
You sue your employer for age discrimination and receive a $40,000 settlement. 

• Your attorney takes 40% ($16,000). 

• You report only the $24,000 you actually receive as income, assuming the legal fees were not paid directly by the defendant. 

• If legal fees are paid directly to your attorney and never included in your reported income, you can't deduct them. But if the fees are included in your gross settlement, you can deduct them—if your case qualifies under the limited exceptions allowed by the IRS. 

Legal Fees: Deductible or Not?

Legal fees follow a complicated set of rules:

• Nontaxable Settlements: If your case involves a physical injury, and the settlement is excludable from income, you cannot deduct attorney fees.

• Discrimination Cases: Legal fees are deductible against the settlement amount if they were included in your gross income.

• Business Lawsuits: If you’re a small business owner and the lawsuit is related to your business activities, legal fees are deductible as a business expense on Schedule C.

• Employee Lawsuits (Non-Discrimination): Legal fees are not currently deductible due to changes under the Tax Cuts and Jobs Act, which suspended miscellaneous itemized deductions from 2018 through 2025.

• Personal Disputes: Suing your neighbor over a barking dog? Not deductible. That’s a personal expense, even if the settlement is taxable.

One More Thing: What Does Your Settlement Agreement Say?
Many settlements are reached privately, and the agreement itself may not specify why money is changing hands. That can create big headaches down the line if the IRS questions your tax return.

Here’s a key rule: the “origin of the claim” governs taxability. If the lawsuit was originally filed due to physical injury or illness, then your settlement may be nontaxable.

Otherwise, it probably isn’t.
That’s why it’s so important to keep all records related to your case, including the original complaint and settlement agreement. Documentation is your best defense if the IRS ever comes calling.

Final Thoughts
Legal settlements can feel like a financial win—but don’t forget about Uncle Sam. While there are exclusions and exceptions, most settlement income is taxable, and it’s essential to understand the nuances before you file your return. When in doubt, consult a tax professional who understands both IRS rules and how to apply them to your unique situation. Just click the link to schedule time to speak with an expert from Lisa Brugman, EA & Associates.