Taxes on a Lawsuit Settlement: The Physical Injury Line Decides It.

A woman settles a wrongful termination case for $300,000. Her attorney takes 40% off the top, $180,000 reaches her account in November, and the following January a Form 1099-MISC arrives reporting the whole $300,000. The taxes on a lawsuit settlement get decided long before that form prints, by what the claim was about and by what the agreement says each dollar is for.

Section 104(a)(2) excludes "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness." Physical is the word doing the work. The IRS looks for observable bodily harm: bruises, cuts, broken bones, a documented sickness. A car crash, a slip and fall, a defective product, medical malpractice. Those recoveries are generally not income at all, and nothing about them goes on the return.

Once a claim clears that bar, the rest of the award rides along. Pain and suffering, loss of consortium, future medical care, and the wages you lost while you were hurt are all received on account of the physical injury, so they come out too.

Punitive damages are taxable, even out of a case that was otherwise entirely about a physical injury. The statute says so in that parenthetical, and the Supreme Court got there first in O'Gilvie v. United States, 519 U.S. 79 (1996): punitive damages punish the defendant rather than compensate the plaintiff, so they are not received on account of the injury. One narrow exception survives in §104(c), for a wrongful death case in a state whose law as of September 13, 1995 allowed only punitive damages, which in practice means Alabama.

Interest is the second piece. Pre-judgment and post-judgment interest is interest income no matter how clean the underlying claim is. The third is a recovery of medical expenses you already deducted: §104(a) pulls the exclusion back to the extent the damages are attributable to deductions allowed under §213 in a prior year. Itemize $22,000 of accident-related medical bills in 2024, get a tax benefit from them, and that much of a 2026 settlement comes back into income.

Outside physical injury, start from the opposite presumption: it's gross income under §61 unless something specific pulls it out, and nothing usually does. Wrongful termination, discrimination, defamation, breach of contract, fraud. The character follows the claim the money replaced, which is the origin of the claim test from United States v. Gilmore, 372 U.S. 39 (1963). Money standing in for wages is taxed like wages, and money standing in for a damaged asset is a return of capital first.

Emotional distress on its own is taxable, which reverses what most people assume. The flush language at the end of §104(a) says emotional distress is not treated as a physical injury or physical sickness. The only slice that escapes is the amount actually paid for medical care described in §213(d)(1)(A) or (B) for that distress, so the therapy bills come out and the rest doesn't. Order matters more than sympathy: distress flowing from a physical injury is excluded, and a physical symptom caused by distress, the insomnia or the ulcer, is not.

Back pay and front pay in an employment case are wages. They belong on a Form W-2, Social Security and Medicare tax comes out, and the employer usually withholds federal income tax at the flat 22% supplemental rate, the same mechanics that apply to severance pay. The non-wage part of the settlement shows up in box 3 of Form 1099-MISC and goes on Schedule 1, line 8z, with no self-employment tax on it.

This is the part that blindsides people. In Commissioner v. Banks, 543 U.S. 426 (2005), the Supreme Court held that when a litigant's recovery is income, that income includes the contingent fee paid to the attorney. It doesn't matter that the defendant wired the fee straight to the law firm. The client who nets $180,000 of a $300,000 settlement reports $300,000.

Through 2017 the fee came back as a miscellaneous itemized deduction, worth something even after the 2% floor and the alternative minimum tax add-back. The Tax Cuts and Jobs Act suspended those deductions under §67(g), and the One Big Beautiful Bill Act made the suspension permanent for tax years beginning after December 31, 2025. There's no sunset left to wait for.

Two carve-outs survive, both above-the-line deductions that work whether or not you itemize. Section 62(a)(20) allows the attorney fees and court costs in a claim of unlawful discrimination, which §62(e) defines to cover the main federal employment statutes, their state and local equivalents, and most whistleblower claims. Section 62(a)(21) does the same for an IRS whistleblower award under §7623. Both are capped at the amount of the recovery you included in income.

The second plaintiff wasn't smarter. The fee deduction tracks the legal theory of the claim, so the question belongs in the drafting of the complaint and the agreement, not in March when the return is on the desk.

The IRS generally respects an allocation in a settlement agreement when it is consistent with the substance of the claims, and disregards one that isn't. That cuts both ways. An agreement that says nothing invites the payer to treat every dollar as taxable, and one labeling 90% of an obvious wage case as emotional distress won't survive an examiner. Publication 4345 is the IRS summary of this, and it runs two pages.

Three things belong in writing before the signature: what each dollar compensates, whether any emotional distress is attributable to the physical injury, and who bears the employment tax on a wage portion. Ask the defendant what forms it plans to issue. Gross proceeds paid to an attorney are reported in box 10 of Form 1099-MISC at $600 under §6045(f), separate from whatever gets reported to you.

If a form does show up for damages that are excludable, don't ignore it. The matching program has no idea the claim was a physical injury, and an unreported 1099 is the most common way a settlement becomes a CP2000 notice a year and a half later. Report the amount, back it out on Schedule 1 citing §104(a)(2), and keep the agreement with the copy of the return.