How to Avoid Paying Taxes on a Lawsuit Settlement

Winning or settling your lawsuit can be exhilarating. After you’ve received the settlement money and paid attorney fees, most people assume that the rest is theirs to keep. However, some settlements are subject to taxes – something most don’t realize until tax time, when much of the money has already been spent. These strategies can help you avoid a nasty, unexpected tax bill by reducing or eliminating the likelihood that you’ll have to pay taxes on a lawsuit settlement.

If you suddenly come into a large amount of money, work with a financial advisor to make the wisest of your windfall.

Factors Affecting a Lawsuit Settlement

According to Internal Revenue Code Section 61, all payments from any source are considered gross income unless a specific exemption exists. However, when you win a settlement, it can be difficult to know whether or not your award is taxable.

These nine common factors help determine taxability.

Physical injury or sickness. Settlements for physical injury or sickness where you’ve demonstrated “observable bodily harm” are not considered taxable by the IRS.
Emotional distress may be taxable. You’ll owe taxes on awards for emotional distress unless the distress originated from the injury or sickness caused by the accident.
Medical expenses: Awards for medical expenses are not taxable as long as you didn’t deduct related medical bills on the prior year’s taxes. If you deducted them last year, then you’ll pay taxes on that amount this year under the IRS “tax benefit rule.”
Punitive damages are taxable. Some judgments and settlements include an award for punitive damages against the defendant. These damages can provide a substantial payout to the plaintiff. The entire punitive damages award is taxable, which can lead to hefty taxes.
Contingency fees may be taxable. If your settlement is nontaxable, legal fees won’t affect your taxable income. Accident and personal injury cases, like a slip-and-fall or workers’ compensation case, are excluded. However, for taxable settlements, you may owe taxes on the full settlement, even when the defendant pays your attorney directly.
Allocate damages to reduce taxes. During settlement negotiations, you can negotiate to allocate a larger portion of the settlement to nontaxable award categories. With this strategy, you could increase the award for physical injuries and illness and decrease the amounts related to emotional distress.
Capital gains instead of ordinary income. Depending on the nature of your claim, you may be able to treat a portion of your settlement as capital gains. If you’ve sued over damage to your home or business, you may be able to classify the settlement as a capital gain. Alternatively, your settlement might qualify as a recovery of tax basis, which is not counted as income.
Spread payments over time to avoid higher taxes. Receiving a large taxable settlement can bump your income into higher tax brackets. By spreading your settlement payments over multiple years, you can reduce the income that is subject to the highest tax rates.

How Settlement Structures Influence Tax Outcomes

Closeup of a gavel resting on top of cash.

The structure of a settlement can shape how much of it becomes taxable, yet this aspect is often overlooked during negotiations.

Cash settlements paid in a single lump sum create an immediate tax-year event that can push taxable portions of the award into higher income brackets. Structured settlements, by contrast, allow taxable components such as emotional distress, punitive damages or interest to be paid out over time. Spreading payments across multiple years lowers your taxable income and can reduce the portion taxed at top marginal rates.

Legal fees also play a role. In many taxable cases, the IRS treats the gross settlement as the plaintiff’s income even when fees are paid directly to counsel. Certain employment, whistleblower and civil rights claims fall under exceptions that permit above-the-line deductions for legal fees, but most other plaintiffs do not receive this treatment. Identifying which category a case belongs to before settlement discussions can prevent surprises and influence how the agreement is drafted.

Multi-claim lawsuits introduce another variable. A single settlement may resolve wage claims, emotional distress, property damage, medical bills and punitive damages at once. Each component carries its own tax rules.

Further Considerations

Allocating the settlement among these categories in a clear, defensible way can determine whether amounts are treated as ordinary income, capital gain, reimbursement of basis or non-taxable compensation for physical harm. Courts and the IRS give significant weight to settlement language when the allocation is reasonable and consistent with the facts of the case.

Interest can also increase the taxable portion of an award. Delayed payment, structured installments and post-judgment interest all generate taxable interest income, independent of the nature of the underlying claim. When negotiators focus only on the headline number and overlook the share attributable to interest, the tax cost can be higher than expected.

A carefully drafted payment schedule can help limit unnecessary interest buildup, especially in cases that have already taken years to resolve.

How to Report a Settlement on Your Tax Return

If you have to report some or all of a lawsuit settlement on your federal tax return, there are some key things you should keep in mind.

First, figure out which parts of the settlement are taxable. Payments for emotional distress (not caused by a physical injury), punitive damages and interest are usually taxable. These amounts are often reported on Form 1099-MISC, and you’ll include them as “Other Income” on your Form 1040.

If your settlement is taxable and related to property damage, you may be able to report part of it as a capital gain. This applies if the amount you receive exceeds your original cost basis in the property. In this case, you’ll report capital gains using Form 8949 and Schedule D. However, if the settlement simply replaces what you lost (your basis), it may not be taxable at all.

Settlements for physical injuries or sickness are generally not taxable, and you don’t need to report them unless you deducted medical expenses in a previous year. If you did, then you’ll need to pay taxes on the portion of the award that covers those previously deducted costs, due to the IRS tax benefit rule.

Keep all documentation that explains how the settlement was broken down. This includes the settlement agreement, attorney fee details, and any 1099 forms. This paperwork helps support your tax return if the IRS asks questions.

A tax advisor can help ensure you report everything correctly to reduce your risk of tax penalties.

Bottom Line

When you receive a settlement, there are numerous factors regarding the jurisdiction, as well as the litigation itself, that will determine whether or not you owe taxes on that amount.

Cash being exchanged over a gavel, symbolizing payment for a lawsuit settlement.

Because there are so many nuances, you’ll want to speak with an attorney and tax advisor to determine which rules apply to your specific situation. When you speak with these professionals, ask how to avoid paying taxes on a lawsuit settlement so you can keep more of the money for yourself.

Financial Planning Tips

A financial advisor can help you create a financial plan for the future. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Paying taxes is an obligation for every investor, whether you invest full-time or as a supplement to your paycheck. However, it can be a challenge to forecast what those taxes will be. SmartAsset’s income tax calculator helps you estimate your taxes owed based on your income, location, filing status, and basic deductions.