What to Know About Filing Taxes Before You File a Lawsuit

I am not a litigator. While I’m licensed to appear in front of the U.S. Tax Court and have appeared in various state and local courtrooms, it’s not my favorite part of being an attorney. This is not to say that I don’t like to argue—my brothers would definitely say that’s not true—but when it comes to representing clients, I prefer to jump on the phone or write a great letter than make an opening statement or perform a cross-examination.

As a practical matter, whenever a case looked like it might go to trial, I usually consulted or engaged a litigator to do the heavy lifting. And, whenever those litigators were finalizing their clients’ settlements and judgments, they often consulted with me. Why? Because they, too, knew when to ask for help.

I know it seems odd to think that tax strategy would play a part in civil cases, but here’s a secret: Most court cases don’t end in a dramatic fashion like you see on television or in the movies. Most civil cases—meaning non-criminal cases—settle.

And while a settlement is typically taxed the same as a judgment, a settlement may allow the parties some wiggle room to suggest a more tax advantageous allocation of damages.

That, of course, raises an important question: When it comes to damages, what is taxable? It’s a question that I’m often asked—not only from litigators, but from taxpayers after a win. Here’s a quick look at what you need to know.

Damages

When it comes to civil damages—money awarded as a remedy for harm—the IRS starts with tax code Section 61: All income is taxable “from whatever source derived” unless exempted by another section of the code. So you should start from the position that damages are taxable unless you can find an exemption.

Compensatory Damages

An award for lost wages is considered compensatory damages. Compensatory damages are intended to make you whole or put you back in the same position you would have been in if the harm had not occurred. That said, wages are wages, whether you get them as part of your regular pay or the result of litigation. That applies to dismissal pay, severance pay, or other payments for involuntary termination of employment. That means they are not excluded from income and are taxed as ordinary income subject to withholding.

It’s worth noting that there are limited exceptions to this rule. A 1985 revenue ruling confirmed the IRS’ position that some compensatory damages, including lost wages, received due to a personal physical injury are excluded from gross income.

Damages for emotional or non-physical harm are not excluded from income. They are taxable even if they are the result of a physical act, such as, for example, unwanted touching that does not result in a physical injury. The same result applies to damages for physical symptoms of emotional distress, like stress headaches.

Gross income does not include physical injuries and physical harm. This would include damages related to medical expenses which have not been previously deducted on your tax return—there’s no double-dipping. You’ll find the exclusion language in Section 104(a)(2), which states that gross income does not include “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”

Similarly, damages for emotional harm requiring medical attention are excluded from gross income. Examples include compensation for medical expenses like payments for mental health visits, as well as prescription medications. You’ll find the applicable language in Reg. Section 1.104-1(c), which notes that “damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2).”

A quick note: If you haven’t pulled out your copy of the tax code in a while, this may take you by surprise. That’s because, before Aug. 21, 1996, Section 104(a)(2) did not contain the word “physical” with regard to personal injuries or sickness.

Punitive Damages

Punitive damages are typically not excluded under the statute and are almost always taxable. Punitive damages are not intended to make you whole but are instead awarded to punish the defendant. The IRS uses the terms “knowingly, willingly, deliberately, recklessly, and fraudulently” to describe behavior associated with punitive damages.

There is a very specific exception to this rule. Under Section 104(c), if a state statute only allows for punitive damages in wrongful death claims, those damages are excluded from gross income.

Fees

The position that damages are taxable unless expressly excluded also applies to the portion earmarked for attorneys’ fees in a contingency case, as confirmed in Commissioner v. Banks. In simple terms, that means that an award may be fully taxable even if there’s an agreement to pay the attorney out of that pool of money. Unfortunately, the tax result doesn’t change if the payor cuts a separate check to the attorney.

Before the 2017 tax law, there was an opportunity to mitigate this tax result by deducting attorneys’ fees. However, since 2018—and through 2025—miscellaneous itemized deductions have been eliminated. An above-the-line deduction may still exist for attorney fees and court costs paid in connection with “unlawful discrimination"—a list of those acts can be found in Section 62(e).

Settlement Asks

When asking for damages during settlement negotiations or seeking a judgment, keep these tax consequences in mind since there may be an opportunity to characterize damages in a tax-favored light. But if you do so, make sure it’s clearly stated in writing: While it has the power to question an allocation, the IRS has acknowledged that it’s “reluctant to override the intent of the parties” in an agreement.

If there’s no way around a taxable settlement or award, there may be an opportunity for the equivalent of a “gross-up” payment—a larger award to make up for the tax consequences. It can also be a good demand in a complaint to offset negative tax consequences resulting from a jury verdict.

And don’t forget to pay attention to timing. It may be possible to structure the payment of damages over time instead of in one amount that pushes a taxpayer in a higher bracket. Additionally, damages tied to compensation may offer other tax planning opportunities, including for retirement or savings.

Document, Document, Document

I always suggest keeping great taxpayer records—and lawsuits are no exception. To help support your tax position, make sure that you keep track of any payments received, by date and kind. Your settlement agreement or damages award should clearly outline the characterization of the payments by amount, as well as note any legal fees or other costs. And hold onto your original petition, complaint, or claim—in the event of an audit, the IRS may ask to see it.

More Information

Lawsuits can be complicated, and tax—well, you already know that tax law is chock-full of exceptions. The result is that the tax results from settlements and judgments from lawsuits are heavily fact and circumstance dependent. Be sure to do your homework before filing your taxes.

If you’re looking for help, the IRS has made Publication 4345 available to taxpayers who may have received proceeds from a lawsuit.

And I always recommend that litigators make friends with tax professionals—we’re handy when you need to ask, “What if?”

This is a weekly column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.