Find out about the tax consequences of legal settlements and lawsuit winnings.
Updated 1/22/2025
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If you're wondering whether you must pay taxes on money won in a lawsuit, you're right to be concerned. The IRS might try to claim its share of the total. According to the tax code, the only damages you can enjoy tax-free are those that compensate you for physical injury or sickness. (26 U.S.C. § 104(a).) If this describes your case, you'll probably keep the cash without fear of IRS taxation. If not, expect a larger-than-usual tax debt at the end of the year.
When the IRS Taxes Lawsuit Settlements and Award
Other reasons exist for awarding money damages besides compensating you for physical injury or sickness, leading to taxable awards. Below, you'll learn about some other situations that could lead to increased tax payments.
Employment Cases
For instance, suppose you had filed an employment discrimination claim against a former employer and won. You receive an award for "back pay," which is the pay you would have received if you had continued to work, and for emotional distress arising out of this traumatic experience. Because none of this award relates to physical harm, almost all of it is taxable at ordinary income rates.
Learn about employment discrimination damages and what you'd recover if you were to win.
Punitive Damage Cases
Another type of award is "punitive damages," which are funds intended to punish the defendant. Even if the underlying case involved injury or sickness, punitive damages are almost always taxable.
Learn about punitive damages in car accident cases.
Tax Rate Increases
The IRS can take a portion of your winnings in another unexpected way. If you receive a lump sum payment for money you would have been entitled to if the defendant hadn't done you wrong, you might suddenly find yourself in a higher tax bracket. You know what that means: higher taxes.
Find out about seven ways to lower your taxes.
When to Get Help
Your personal injury lawyer might be able to provide general insight into your tax situation but most probably won't be well-versed in the tax code. Instead, consulting an accountant or tax professional will help you avoid surprises and be well worth your time.
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