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. Unfortunately, many people don’t realize it until tax time the following year, after much of the money may have been spent. To avoid a nasty, unexpected tax bill, this article will show you how to reduce or eliminate the likelihood that you’ll have to pay taxes on a lawsuit settlement.

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Factors Affecting a Lawsuit Settlement

Closeup of a gavel resting on top of cash.

According to Internal Revenue Code Section 61, all payments from any source are considered gross income unless a specific exemption exists. When you win a settlement, it can be difficult to know whether or not your award is taxable without analyzing the details. This list highlights nine common factors that 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 worker’s 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. For example, increase the award related to physical injuries and illness and decrease 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 factory, 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 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 is more than your original cost basis in the property. In that case, you’ll report the gain using Form 8949 and Schedule D. On the other hand, 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 claimed related medical expenses as a tax deduction 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 also help you report everything correctly and reduce your risk of penalties.

Bottom Line

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

When you receive a settlement, there are numerous factors regarding the litigation itself, as well as the jurisdiction, that determine whether or not you’ll owe taxes on that amount. 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, you may learn how to avoid paying taxes on a lawsuit settlement and 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.