Are Personal Injury Settlements Taxable? What the IRS Says

Most personal injury settlements are not taxable. Federal law excludes damages received "on account of personal physical injuries or physical sickness" from income, under 26 U.S.C. §104(a)(2).

The parts that can be taxed are punitive damages, interest, reimbursed medical costs you already deducted, and damages in cases with no physical injury. How your settlement agreement labels each dollar affects which bucket it lands in.

What does §104(a)(2) exclude?

It excludes all compensatory damages that flow from a physical injury. That covers medical bills, pain and suffering, and lost wages, as long as the claim started with a physical injury or physical sickness.

Lost wages surprise many people. The IRS's own guidance on settlements and judgments cites Rev. Rul. 85-97: the entire amount received for personal injuries in an accident, "including the portion of the amount allocable to the claim for lost wages, is excludable."

The word "physical" matters. Congress added it to §104(a)(2) effective August 21, 1996. Since then, settlements for claims like defamation or workplace discrimination, with no physical injury, are generally taxable.

Emotional distress that comes from a physical injury is treated the same as the physical injury itself. IRS Publication 4345, Settlements — Taxability, says so directly.

Does it matter if you settle or win at trial?

No. The exclusion applies to damages received "whether by suit or agreement," so a jury verdict and a negotiated settlement get the same treatment.

The same is true for how you are paid. Section 104(a)(2) covers damages paid "as lump sums or as periodic payments," so a structured settlement paying $2,000 a month for 20 years is excluded just like a single check.

Which parts of a settlement are taxable?

Punitive damages

Punitive damages are taxable even in a car crash or other physical injury case. Publication 4345 says to report them as "Other Income." The only exception, in §104(c), covers certain wrongful death cases in states where only punitive damages are available.

Interest

Interest on a judgment or settlement is taxable as interest income, even when the underlying damages are tax-free. This usually comes up after a trial verdict, when judgment interest runs until the defendant pays.

Emotional distress without a physical injury

Damages for emotional distress alone are taxable. You can exclude the part that pays for medical care of that distress, such as therapy bills, if you did not already deduct those costs.

Lost wages in non-physical cases

In an employment case, back pay is taxable wages and subject to employment tax withholding. IRS Publication 525 lists "back pay and damages for emotional distress received to satisfy a claim under title VII" as income.

Compare that with a car crash victim who receives $60,000 for a broken wrist, lost wages and the anxiety that followed. None of that $60,000 is taxable, because every dollar traces back to a physical injury.

What is the tax benefit rule?

If you deducted medical expenses in an earlier year, and that deduction lowered your tax, the part of your settlement that repays those expenses is taxable. The opening of §104(a) and Publication 4345 both set out this rule.

Many people never hit it. Medical expenses are deductible only above 7.5% of adjusted gross income under §213(a), and only if you itemize on Schedule A.

Are you taxed on the lawyer's share?

For the taxable parts, yes. In Commissioner v. Banks, decided January 24, 2005, the Supreme Court held that a contingent fee paid out of a taxable recovery is part of the client's gross income.

In the example above, if your lawyer takes 33% of the $50,000 punitive award, you still report the full $50,000. For the $180,000 physical injury portion, the fee question does not arise because that money is excluded.

Discrimination claims are handled differently. Publication 525 describes a separate deduction for costs involved in unlawful discrimination suits.

Where do taxable amounts go on your return?

Publication 4345 sorts them by type. Punitive damages and taxable reimbursements of medical costs you deducted earlier go on Schedule 1 of Form 1040 as other income.

Interest goes on Form 1040 as interest income. Back pay from an employment claim is reported as wages, and the employer should withhold payroll taxes from it.

Nothing is reported for the excluded physical injury portion. If you receive a Form 1099 that includes excluded money, keep the settlement agreement with your tax records so you can show why it is not income.

Why does the settlement's allocation language matter?

The IRS starts with the settlement agreement. If the agreement is silent, the IRS says it "will look to the intent of the payor" to characterize the payments and decide what goes on a Form 1099.

A clear allocation paragraph protects you. It should state the amount paid "on account of personal physical injuries or physical sickness" under §104(a)(2), and separately list any punitive damages or interest.

The allocation should match the claims you actually made. A lawsuit that sought only emotional distress damages will not support an allocation to physical injury.

When a settlement includes taxable income, the payer must report the attorney's fees on separate information returns naming the lawyer and you. That is how a Form 1099-MISC can show up for money you never held.

What should you do before you sign?

• Ask your lawyer to include a §104(a)(2) allocation paragraph in the release, with punitive damages and interest listed separately.
• Ask whether the defendant or its insurer plans to issue a Form 1099, and for which amounts.
• Pull your returns from the years since the injury. If you itemized medical expenses on Schedule A, flag them.
• Keep the signed settlement statement showing the gross amount, fees, costs and liens paid.
• If any part is taxable, a short meeting with a tax professional before filing is worth it.

For how the gross figure is built, see our guides to how settlements are calculated and pain and suffering damages.