Do I Have to Pay Tax on My Lawsuit Winnings?

You've settled a claim or won a lawsuit, and collected the money you're owed. Do you have to pay tax on your winnings?

The answer is: It depends on what your lawsuit was about. If you got compensation ("damages") for physical personal injuries, most or all of your recovery will be federal income tax free. The same might be true if you've collected money for property damages. Otherwise, there's a good chance your winnings will be taxable.

Our discussion focuses on federal income taxes under the Internal Revenue Code (the Code). While most states with an income tax tend to follow the Code, that's not always true. Speak to your tax advisor for guidance specific to your case.

The General Rule: All Income Is Taxable

When you're trying to figure out if income (like from a settlement or judgment) is taxable, here's your presumptive starting point: It's fully taxable.

Why start with that presumption? Because that's what the the Code says. Gross income for tax purposes includes "all income from whatever source derived... ." (26 U.S.C. § 61(a) (2025).)

That leads to the general rule: All income—regardless of what it's for—is taxable, unless you find a rule that says it's not. In other words, absent a Code provision that excludes your lawsuit winnings from income, you should presume those winnings are fully taxable.

What Lawsuit Winnings Are Tax Free?

The Code has several exclusions from gross income, but only one relates to lawsuit winnings. In addition, the Code sometimes allows payments for property damages to escape taxation.

Exclusion for Personal Injury Winnings

Under 26 U.S.C. § 104(a) (2025), gross income doesn't include:

• workers' compensation payments for personal injuries or sickness, and
• damages—other than punitive damages—for "personal physical injuries or physical sickness."

These exclusions mean you don't have to pay federal income tax on a settlement or money judgment from a workers' compensation or personal injury case if the money you received was for:

• actual, physical injuries, including emotional injuries related to your physical injuries, or
• income or earnings you lost because of actual, physical injuries.

Note, importantly, that not all personal injury damages are tax free. As mentioned above, punitive damages—while rare in most injury cases—are taxable. So are winnings for mental anguish and emotional distress unrelated to any physical harm. Finally, interest on your judgment is also subject to income tax.

(Learn more about the taxability of personal injury winnings.)

Property Damage Winnings Might Be Tax Free

Suppose your car gets damaged in a wreck. You bring a property damage claim against the responsible driver, which eventually settles for a cash payment. Is that payment taxable?

Probably not. As long as the payment doesn't exceed your "tax basis" in the car—meaning the amount you have invested in it—the payment simply reduces your tax basis by that amount. Your tax basis includes:

• the cash you paid, plus
• any purchase money or improvement loan you're obligated to repay.

When the amount you were paid is more than your tax basis, you'll pay tax on the resulting gain.

Here's a quick example. You bought a classic car for $40,000, putting down $8,000 in cash and financing the $32,000 balance. Your total investment in the car—your tax basis—is $40,000. A few months later, a careless driver ran a stop sign and hit you, causing $15,000 in property damage. The other driver's auto insurer wrote you a check for that amount.

What's the tax consequence of this payment? The $15,000 payment is federal income tax free. But it reduces your tax basis in the auto to $25,000 ($40,000 - $15,000).

Now, let's change the facts a bit. Suppose the wreck left your vintage car a total loss. Because it was a classic, the car's value actually went up between the date you bought it and the date of the accident. As a result, the other driver's insurance company settled with you for $42,000.

On these facts, you'll owe a bit of tax. The first $40,000 is tax free, but your tax basis is reduced to zero. The remaining $2,000 is treated as a gain and will be taxed.

Other Lawsuit Winnings Are Taxable

Here's the question the Internal Revenue Service (IRS) will ask when it thinks your lawsuit winnings might be taxable: What was the money you received meant to replace? If your winnings are for anything other than damages you can exclude under § 104(a) or property losses, be ready to pay federal (and probably state) income tax on your recovery.

Employment Cases

You file a claim against your former employer under federal and state employment discrimination laws. Your claims eventually settle for an award of "back pay"—the pay you would have received had you continued to work—and for emotional distress arising out the discriminatory treatment.

Your entire settlement is taxable. The payment is meant to replace lost wages and to compensate you for emotional harms unrelated to any physical injuries. Because the settlement can't be excluded under § 104(a), you'll pay tax on it at the same rate you pay for wages and other ordinary income.

(Learn about employment discrimination damages and how to determine the proper tax treatment for them.)

Defamation

A business competitor publishes false factual claims about you, damaging your reputation in the community. As a result, you lose income and other business opportunities. You sue, and later negotiate an out-of-court settlement for lost earnings and other reputational harms.

This settlement, too, is fully taxable. As with claims for employment discrimination, discussed above, this settlement is meant to replace lost income and non-physical harm to your reputation. None of the proceeds can be excluded from taxable income.

Business Deals Gone Bad

Suits over bad business deals—typically involving claims of contract breach, unfair competition, stolen trade secrets or business opportunities, or similar misconduct—usually boil down to lost income, increased expenses, or decreased business values. In other words, they involve losses and damages that are likely to be taxable.

In each case, as mentioned above, keep in mind the touchstone question: What is this lawsuit recovery meant to replace? Especially when complex business arrangements and multiple claims are involved, think about getting qualified tax advice. Go it alone and you're much more apt to make a costly mistake.

Can You Structure a Settlement to Make It Nontaxable?

Imagine you've got a case involving what look like taxable claims. Can you structure a settlement so there's a chance to avoid at least some tax?

Maybe. Remember that for an injury settlement or judgment to escape taxation, it must be payment for actual, physical injuries, for emotional harms related to physical injuries, or for lost income attributable to physical injuries. To have any hope of avoiding tax, your claim or lawsuit should seek recovery for those specific kinds of injuries.

When you later settle the case, you can argue that at least some portion of your recovery qualifies for exclusion under § 104(a). The settlement agreement should allocate payments between taxable and nontaxable harms. There's no guarantee, of course, that the IRS will accept your allocation. But an arm's length agreement gives you a way to negotiate.

This kind of tax planning requires special expertise. Unless you're a tax specialist, don't try it on your own. The time to start planning is when you bring your initial claim, or if you sue, when you're filing your lawsuit. Consult with a tax lawyer early on, and make sure they're involved at the settlement stage as well.

Get Help With Your Tax Questions

If you've ever tried to prepare and file your own tax return, you know that the Code is among the most complicated and difficult to understand of all laws. It's easy to make a mistake that can end up in a hefty bill for back taxes, penalties, and interest. Don't take needless chances with your lawsuit settlement or judgment.

If you're unsure about the tax treatment of your winnings, or if you want to plan a settlement to minimize your tax obligations, there's no substitute for professional advice. A tax lawyer, CPA, or tax advisor can guide you through the maze of laws and rules, and help you lawfully keep more of your hard-earned damages.