Legal Settlement – Taxable vs. Nontaxable
The taxability of any settlement or judgment depends on what the payment is intended to replace; its character mirrors the nature of the underlying claim. Items treated as ordinary income generally include:
- Interest paid on an award or settlement.
- Payments for lost wages or lost business income, in most situations.
- Punitive damages, even when connected to a physical injury or physical illness claim.
- Settlement amounts for pension rights when the taxpayer did not pay into the plan.
- Damages relating to business or contract matters, such as:
- Patent or copyright violations,
- Breach of contract claims,
- Disruption or interference with business activities.
- Back pay and emotional-distress damages tied to claims under Title VII of the Civil Rights Act of 1964. Back pay is taxable; emotional-distress damages are taxable unless they are directly related to physical injury.
- Attorney fees and litigation costs (including contingent fees) when the associated recovery must be included in gross income.
- Attorney fees are connected to whistleblower awards when the underlying award is taxable.
NOTE: Payments intended to compensate for personal physical injuries or physical illness, whether they are paid all at once or over a longer time, are not included in income.
See Form 1040 – Other Income FAQ for more information about entering other income.
Related Links
- IRS Publication 525
- IRS Publication 4345
- IRS Publication 17