Are lawsuit settlements taxable?

The test

Publication 17 begins with the principle: to determine whether settlement amounts you receive by compromise or judgment must be included in income, you must consider the item that the settlement replaces. The character of the income as ordinary income or capital gain depends on the nature of the underlying claim. Practically, you read the settlement agreement or judgment and sort each dollar by what it compensates you for.

What is excluded

Pub. 17 says do not include in your income compensatory damages for personal physical injury or physical sickness, whether received in a lump sum or installments. Emotional distress itself is not a physical injury or physical sickness, but damages for emotional distress due to a physical injury or sickness are treated as received for the physical injury or sickness, so they are not income either.

What is taxable

The publication lists items to include as ordinary income: interest on any award; compensation for lost wages or lost profits in most cases; punitive damages in most cases, whether or not they relate to a physical injury or physical sickness; amounts received in settlement of pension rights if you did not contribute to the plan; damages for patent or copyright infringement, breach of contract, or interference with business operations; back pay and damages for emotional distress received to satisfy a claim under title VII of the Civil Rights Act of 1964; attorney fees and costs, including contingent fees, where the underlying recovery is included in gross income; and attorney fees relating to whistleblower awards where the underlying recovery is included in gross income.

A common surprise is a settlement for a physical injury that includes both medical compensation and punitive damages. The first part is excluded; the second is taxable. Another is lost wages: even when your injury was physical, the part of the award replacing wages you did not earn is not excluded in the way the physical injury compensation is.

Emotional distress without a physical injury

If the emotional distress comes from a personal injury that is not a physical injury or sickness, such as employment discrimination or injury to reputation, you must include the damages in income, except for any damages that are not more than the amounts you paid for medical care due to that distress. Emotional distress includes physical symptoms that result from it, such as headaches, insomnia, and stomach disorders. So if you received $10,000 for distress from a discrimination claim and paid $1,200 for therapy, $1,200 is excluded and $8,800 is taxable.

Worked example

A settlement totals $186,500 and is allocated: $100,000 compensatory damages for a physical injury, $5,000 for emotional distress caused by that injury, $10,000 for emotional distress from a separate non-physical claim (you paid $1,200 of medical care for it), $20,000 for lost wages, $50,000 in punitive damages and $1,500 of interest. The excluded amount is $100,000 + $5,000 + $1,200 = $106,200. The taxable amount is $8,800 + $20,000 + $50,000 + $1,500 = $80,300. Enter these in the calculator above and you get the same split; the two amounts add back to $186,500.

Attorney fees

If a contingent fee is deducted from the settlement before you receive it, the whole recovery can still be your income when the underlying recovery is taxable; that is why the publication lists attorney fees and costs as included. Pub. 17 also lets you deduct attorney fees and court costs for actions settled or decided after October 22, 2004 that involve a claim of unlawful discrimination, a claim against the U.S. Government, or a claim under section 1862(b)(3)(A) of the Social Security Act. This is an adjustment to income on Schedule 1 (Form 1040), line 24h, limited to the amount of the judgment or settlement you include in income for the year. Pub. 525 has more.

Limits and next steps

This page is a summary of the Pub. 17 list, not a legal opinion about your case; the allocation in a settlement agreement can be complicated, and business, wrongful-death and other claims have their own rules in Pub. 525. Keep the complaint, settlement agreement and any Form 1099 you receive. Estimate the extra tax with the federal income tax calculator and the brackets. A large taxable award may require estimated tax payments, and if the money replaced medical costs, the medical expense deduction may interact with it.

Sources

• IRS Publication 17, Your Federal Income Tax (2025): Court awards and damages under Miscellaneous Income (chapter 8); Unlawful Discrimination Claims (chapter 12). Read November 2, 2026.

Edition read: Publication 17 (2025), Your Federal Income Tax, for use in preparing 2025 returns. Dollar limits and dates are for the 2025 tax year unless the text says otherwise; check the current publication and form instructions for your tax year. This page summarizes the publication and does not replace it.