Do You Pay Taxes on Lawsuit Settlements? 5 Common Examples

HomeSettlement Tax PlanningDo You Pay Taxes on Lawsuit Settlements? 5 Common Examples

Have you ever wondered: “Do you pay taxes on lawsuit settlements?” This article will help you answer that question.

Settlement taxes can be confusing, and paying taxes on lawsuit settlements is a reality many plaintiffs face. In this article, we will walk through the tax implications of five common types of legal settlements so you can see which applies to you and be prepared for your own settlement. 

For each case type, we’ll explain the underlying tax law. Why? Because understanding the tax consequences of your potential settlement can make a huge difference in how much of your settlement you actually get to keep. 

Please note that the information in this article is intended for general informational purposes and is not intended to be tax advice.

What to Expect: a Quick Overview

In this article, we’ll cover the taxation of five types of legal settlements:

  1. Personal injury
  2. Employment
  3. Defamation
  4. Legal tax or financial malpractice
  5. And cases with punitive damages

After covering the taxation of each of these case types, we’ll share some strategies you can use to legally keep more of your settlement money and pay as little as possible in taxes.

1. Personal Injury Cases

Let’s start with the good news. The compensation you receive for a personal injury case is generally tax-free. 

Common types of personal injury cases that would be tax-free include:

  • Car accident
  • Slip and fall
  • Dog bite
  • Medical malpractice

Section 104(a)(2) of the Internal Revenue Code (the US Tax Code) excludes settlement money paid as a result of “personal physical injuries or physical sickness.” 

In addition, any settlement you receive that stems from a personal injury is also tax-free.

For example, if you’re receiving a settlement and you’re being compensated for medical expenses, lost wages, pain and suffering, and loss of future earning capacity, as long as those losses stem from a personal physical injury, the entire settlement you receive is tax-free. This means you won’t have to pay any income taxes on your settlement. 

That’s good news for many plaintiffs. In most situations, you don’t even have to report a personal physical injury lawsuit settlement on your tax return.

However, if part of the money you get from a personal injury settlement is for punitive damages — something we’ll cover later in this article — you should know that the punitive damage portion will be taxed. 

2. Employment Cases

Settlements for employment cases are always taxable to the plaintiff (meaning you have to pay taxes on these lawsuit settlements).

The big question plaintiffs in employment cases must ask themselves is:

Can I deduct my attorney’s legal fees on my tax return? 

In some cases, you can deduct your attorney’s legal fees, and in some instances, you won’t be able to — and the answer to this question greatly impacts your tax bill.

In general, if your employment case involves discrimination or retaliation because you are a protected class member, you can deduct your legal fees on your tax return, and you won’t have to pay taxes on that amount (you’d only pay tax on the remaining amount).

For example, let’s say you were discriminated against at work because of your race, age, gender, disability, or national origin (all classified as a protected class). In this instance, you could deduct your legal fees above the line* on your tax return

As a result, thanks to the above-the-line deduction in our example discrimination case, you would only pay taxes on the net settlement amount that you actually receive after paying your legal fees. 

* Note: An above-the-line deduction means that you can deduct those expenses from your gross income. After you’ve taken all the above-the-line deductions on your tax return, you’re left with your “adjusted gross income,” which is the amount you pay tax on.

Most employment cases qualify for the above-the-line deduction. That’s good news. 

But let’s say you file an employment lawsuit for harassment where your employer and fellow employees engaged in unwelcome behavior directed at you that was not necessarily based on any protected characteristic. 

Examples:

  • Your employer spread malicious rumors about you or undermined your efforts to get a promotion.
  • Your employment contract stated you were supposed to get a 5% bonus, and your employer refused to pay that bonus, and you sued your employer for a breach of employment contract to recover your 5% bonus. 

In these scenarios, because the lawsuit isn’t about you being a protected class member and you weren’t retaliated against, the total settlement would be taxed, and you would not be able to take an above-the-line deduction on your personal tax return for your attorney’s fees. 

This inability to take an above-the-line deduction stems from the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA removed the miscellaneous itemized deduction for the tax years between 2018 and 2025, which was the main way plaintiffs had used previously to write off attorney’s fees. 

This change in the tax law has led to unfair results where plaintiffs often pay taxes on the full gross recovery, even if 30 to 40 percent went towards legal fees. 

That would mean, for example, if the total settlement amount was $10 and the attorney’s fee was $4, you’d have to pay tax on the full $10, even though you only received $6. 

That is painful. 

do you pay taxes on lawsuit settlements full settlement example
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do you pay taxes on lawsuit settlements settlement tax

Again, all employment lawsuits are taxable (meaning you must pay income taxes on the money you receive from the lawsuit). The question is whether you can deduct the legal fees paid to your attorney as an above-the-line deduction on your tax return.

Above-the-line deduction (only pay tax on your net settlement): A settlement from an employment discrimination or retaliation lawsuit related to you being a protected class member. 

Not eligible for an above-the-line deduction (pay tax on the full amount of the settlement, including the amount paid to your attorneys): A settlement from an employment lawsuit unrelated to being a protected class member. 

Spoiler alert: There are tax planning strategies you can use in employment cases to reduce your taxes, regardless of whether you can deduct your legal fees or not, which we’ll cover later in this article. 

3. Defamation, Libel, or Slander Cases

Defamation lawsuits, including claims of libel or slander, receive very harsh tax treatment. 

The entire settlement amount in a defamation case is considered taxable income, and this includes any damages awarded for emotional distress, reputational harm, lost profits, and punitive damages. 

Therefore, unlike employment discrimination or retaliation cases based on a protected class, plaintiffs in defamation lawsuits cannot deduct their legal fees above the line on their tax returns. 

And again, due to the Tax Cuts and Jobs Act of 2017, there’s really no way to avoid paying taxes on legal fees other than the tax strategy outlined later in this article. 

Plaintiffs in defamation cases who don’t do tax planning pay tax on their full gross settlement (even if 30% to 40% went towards legal costs and fees). 

4. Legal, Tax, or Financial Malpractice Cases

Settlements from legal, tax, or financial malpractice lawsuits also receive harsh tax treatment. 

The entire settlement amount is considered taxable income to the plaintiff, and after the Tax Cuts and Jobs Act, plaintiffs in professional malpractice cases are also unable to deduct legal fees on their own tax returns. Again, this results in plaintiffs paying taxes on the full gross recovery, even though a significant portion of the settlement went to pay legal fees and costs. 

So, like defamation settlements, malpractice settlements face the double taxation whammy: Plaintiffs are taxed on the gross amount with no deduction for legal fees. 

Note: By using the tax planning strategy we cover later in this article, plaintiffs can avoid an unfair tax hit in these types of cases. 

5. Cases with Punitive Damages

Any case with punitive damages is taxable. 

The tax code is clear that any punitive damage awards are fully taxable, even if the rest of the settlement is tax-free. 

For example, a plaintiff receiving both compensatory and punitive damages for physical injuries would still need to pay taxes on the full amount of the punitive damages. The compensatory damages would be tax-free, but the punitive portion would be fully taxed. 

In addition, just like in defamation or professional malpractice lawsuits, after the Tax Cuts and Jobs Act, plaintiffs cannot deduct legal fees related to punitive damages. This results in plaintiffs paying taxes on the full gross amount of the punitive damages, even though a significant chunk goes towards legal fees and costs. 

The tax bill on punitive awards can be shockingly high. 

Two Tax Planning Strategies for Maximizing Your After-Tax Recovery

Now that we’ve explored how five common case types are taxed, it’s time to look at two tax planning strategies you can use before settlement to reduce how much you’ll have to pay in taxes. These two proven tax planning tools can significantly increase your after-tax settlement recovery

  1. The first tool is called a structured settlement annuity. It works in all of the case types we’ve covered today. 
  1. The second tool is called the Plaintiff Recovery Trust. The Plaintiff Recovery Trust is only needed in cases where legal fees cannot be deducted. Non-deductible case types include certain employment cases not based on discrimination or retaliation, defamation, professional malpractice, and cases with punitive damages. 

Let’s take a closer look at each of these tools and how they can help reduce a plaintiff’s tax bill. 

1. Structured Settlement Annuities

A structured settlement annuity allows plaintiffs to spread out the receipt of their settlement over multiple years rather than receiving it all in the year that they received the settlement. 

Instead of taking the full settlement all at once, some or all of the settlement funds are used to buy a structured settlement annuity. An annuity takes the taxable lump sum settlement and parcels it out into customized regular payments over three, five, ten, or twenty or more years (whatever time frame the plaintiff chooses). 

This setup enables the plaintiff to spread out their taxable settlement over many years rather than receiving it all in one year. By doing so, the plaintiff is only taxed when they receive the annuity payments in the future. 

So why does this save on taxes? 

By spreading out the settlement, the plaintiffs ideally lower their marginal tax rate and pay taxes at a lower rate each year they receive those payments. 

Lowering your marginal tax rate* results in significant tax savings by putting the plaintiff in a lower tax bracket each year over the life of the annuity, compared to owing taxes on the full lump sum the first year after settling at the highest tax rate. 

*Note: The marginal tax rate is the tax rate at which your last dollar of income is taxed. Your marginal tax rate is the highest tax rate your income is taxed at.) 

In addition, the funds inside the annuity earn a guaranteed rate of return. This means the total amount paid to the plaintiff from the annuity is more than what they would have received via a one-time lump sum. 

Beyond tax-related perks, annuities come with other added benefits. 

First, they provide guaranteed payments, which can even be lifetime payments if that’s what you desire. 

Second, a structured settlement annuity and its guaranteed payments act as a safeguard to prevent the premature dissipation or spending of the settlement proceeds. 

2. The Plaintiff Recovery Trust

For taxable settlements where attorney’s fees cannot be deducted, like certain employment cases, defamation, professional malpractice, and any case with punitive damages, the Plaintiff Recovery Trust is a hugely important tax savings tool

In these case types, the Plaintiff Recovery Trust is the only legal option that allows the plaintiff to avoid being taxed on legal fees that their attorney receives. Without the Plaintiff Recovery Trust, plaintiffs must pay tax on the full gross recovery, even the portion they pay to their attorneys as legal fees. With the Plaintiff Recovery Trust, plaintiffs only pay tax on the money they actually receive, which is the amount left over after paying their attorney fees. 

In our $10 settlement example, with $4 going to attorney’s fees, the plaintiff would have to pay tax on the entire $10 if they do not use the Plaintiff Recovery Trust.

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do you pay taxes on lawsuit settlements tax

With the Plaintiff Recovery Trust, the plaintiff would only have to pay tax on the $6 they actually receive. Working with plaintiffs, we find that the Plaintiff Recovery Trust alone can double or even triple what the client ends up with after taxes.

Which tax strategy will work for your case type?

PERSONAL INJURY CASES

Does a structured settlement annuity help in a personal injury case?

Yes, but not for the reason you might think. 

As we discussed, the settlement is generally tax-free in a personal injury case. A structured settlement annuity is not needed for tax savings in a personal injury case like it might be in a taxable case. 

Why? Because there aren’t any taxes on the personal injury settlement. 

However, if you took a tax-free settlement from a personal injury case and put that money in a bank account or invested it in the market, any interest or growth you earn on those investments would be taxable. 

Here’s where an annuity can help in a personal injury case: The IRS specifically allows personal injury plaintiffs to place funds from their settlement into an annuity, and the interest and growth earned within the annuity are also tax-free when those payments are received in the future. Thus, the payments from a structured settlement annuity would always be 100% tax-free even though the payments include investment growth inside of the annuity. 

That’s a unique tax benefit of a structured settlement annuity for personal injury plaintiffs. 

Does the Plaintiff Recovery Trust help in a personal injury case?

No. Because the entire settlement is tax-free, there’s no need to deduct any legal fees. As a result, you don’t need the Plaintiff Recovery Trust in a personal physical injury case. 

The only exception is if there are punitive damages that are awarded as part of that personal injury case. 

EMPLOYMENT CASES

Does a structured settlement annuity help in employment cases?

Yes, because employment cases are always taxable, a structured settlement annuity helps reduce a plaintiff’s tax bill in employment by spreading out the receipt of the settlement over several tax years, which lowers the plaintiff’s marginal tax rate and, therefore, maximizes the after-tax recovery. 

Does the Plaintiff Recovery Trust help in employment cases?

It depends

  • The Plaintiff Recovery Trust is not needed in employment cases involving discrimination or retaliation because legal fees are deductible in those types of cases. 
  • The Plaintiff Recovery Trust is only needed in employment cases where legal fees are not deductible (in employment cases where the lawsuit is not based on discrimination or retaliation because the plaintiff is a member of a protected class) 

In these non-protected class lawsuits, the Plaintiff Recovery Trust allows plaintiffs to only pay taxes on the portion of the settlement that they receive and not on the entire settlement, providing huge tax savings. 

DEFAMATION CASES

Does a structured settlement annuity help in a defamation case?

Yes, because defamation lawsuits are always taxable, a structured settlement annuity reduces taxes by spreading out settlement payments over multiple years. 

Rather than paying a huge tax bill if the settlement is received in one lump sum, the plaintiff pays taxes annually as they receive each annuity payment. Spreading out the settlement can result in much lower total taxes being paid.

Does the Plaintiff Recovery Trust help in defamation cases?

Yes, because legal fees in defamation cases are not deductible after the Tax Cuts and Jobs Act. 

The Plaintiff Recovery Trust can be used to avoid paying taxes on the legal fee paid in a defamation case. In defamation cases, the Plaintiff Recovery Trust alone can often double what plaintiffs get to keep after taxes. Using both a structured settlement annuity and the Plaintiff Recovery Trust can often triple the after-tax recovery for defamation plaintiffs compared to receiving a lump sum settlement without any planning. 

Does a structured settlement annuity help in legal, tax, or financial malpractice cases?

Yes, absolutely. 

Because these types of malpractice cases are always taxable, a structured settlement annuity can help reduce taxes by spreading out the settlement recovery over several years. 

Does the Plaintiff Recovery Trust help in legal, tax, or financial malpractice cases?

Yes, because legal fees in legal, tax, or financial malpractice cases are not deductible. 

The only way to avoid getting taxed on the amount paid in legal fees in these types of cases is to use the Plaintiff Recovery Trust. Using both the structured settlement annuity and the Plaintiff Recovery Trust can often triple the after-tax recovery for professional malpractice lawsuits. 

CASES WITH PUNITIVE DAMAGES

Does a structured settlement annuity help in cases where there are punitive damages?

Yes.

Because punitive damages are always taxable, spreading the settlement over multiple years can reduce the total tax paid significantly. Rather than paying a massive tax bill on a lump sum in the year you receive a settlement, you can pay taxes over several years as you receive those annuity payments.

Does the Plaintiff Recovery Trust help in cases with punitive damages?

Yes. Legal fees attributed to punitive damages cannot be deducted on the plaintiff’s tax return. 

Without the Plaintiff Recovery Trust, the plaintiff will pay taxes on the total amount of punitive damages, including the amount of legal fees attributable to the punitive damage portion of the settlement. 

With the Plaintiff Recovery Trust, the plaintiff only pays taxes on the settlement amount they actually receive. 

Plaintiffs receiving punitive damages can use both a structured settlement annuity and the Plaintiff Recovery Trust to dramatically increase — often triple their after-tax net settlement

Conclusion: Strategies for Keeping More of Your Settlement

What is the key takeaway? While lawsuit settlement taxes can be confusing, there are ways for plaintiffs to legally minimize taxes and maximize their take-home recovery. When used correctly, strategies like a structured settlement annuity and the Plaintiff Recovery Trust can literally double or triple the net amount plaintiffs get to keep after paying taxes

We’ve covered a ton of ground in this article, and it’s easy to see why settlement taxes have so many plaintiffs worried and confused. But we’re here to help you navigate the complexities of settlement taxation.

If you’re receiving a settlement soon and you want to keep more of your hard-won settlement proceeds, our firm is here to help you. We offer a free, no-obligation, 15-minute phone call for plaintiffs nationwide

On our call, we will gather information so we can provide you with a free, 100% customized analysis showing how much more money you could save by implementing the tax planning strategies outlined in this article. 

Even if you decide you don’t want our firm to help you set up these strategies, you’ll walk away with invaluable education on reducing your settlement taxes. 

If you want a sneak peek at how much these tax planning strategies can save you, check out our free settlement tax savings calculator. This calculator will estimate how much you’ll pay in taxes on your settlement — and most importantly — it will show you how much more money you can keep by using one or more of the strategies we shared in this article. 

Please note: All of the tax planning strategies we outlined must be set up before you receive the settlement

So, please don’t wait to reach out. If you wait until after you receive your settlement, it’s too late to use any of the strategies we shared in this article — and there’s not much we can do to help you save on settlement-related taxes. 

So, make sure to book your call now by clicking the button below. We look forward to speaking with you soon!

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