Are Lawsuit or Settlement Damages Taxable?

Share this Article
Facebook Icon LinkedIn Icon Twitter Icon
Matthew L. Roberts

Matthew L. Roberts



Mr. Roberts is a Principal of the firm. He devotes a substantial portion of his legal practice to helping his clients successfully navigate and resolve their federal tax disputes, either administratively, or, if necessary, through litigation. As a trusted advisor he has provided legal advice and counsel to hundreds of clients, including individuals and entrepreneurs, non-profits, trusts and estates, partnerships, and corporations.

Having served nearly three years as an attorney-advisor to the Chief Judge of the United States Tax Court in Washington, D.C., Mr. Roberts leverages his unique insight into government processes to offer his clients creative, innovative, and cost-effective solutions to their tax problems. In private practice, he has successfully represented clients in all phases of a federal tax dispute, including IRS audits, appeals, litigation, and collection matters. He also has significant experience representing clients in employment tax audits, voluntary disclosures, FBAR penalties and litigation, trust fund penalties, penalty abatement and waiver requests, and criminal tax matters.

Often times, Mr. Roberts has been engaged to utilize his extensive knowledge of tax controversy matters to assist clients in their transactional matters. For example, he has provided tax advice to businesses on complex tax matters related to domestic and international transactions, formations, acquisitions, dispositions, mergers, spin-offs, liquidations, and partnership divisions.

In addition to federal tax disputes, Mr. Roberts has represented clients in matters relating to white-collar crimes, estate and probate disputes, fiduciary disputes, complex contractual and settlement disputes, business disparagement and defamation claims, and other complex civil litigation matters.

Are Lawsuit or Settlement Damages Taxable?

Taxpayers who suffer from physical injuries or physical sickness can generally take advantage of a special provision in the Code that makes such damages non-taxable.  See I.R.C. § 104(a)(2).  Generally, this can be an easy determination.  However, what happens if the taxpayer is engaged in a lawsuit and receives damages through a judgment or settlement?  How does the IRS know if those damages are subject to non-taxation under I.R.C. § 104(a)(2)?

Generally, federal courts and the IRS characterize judgment and settlement payments according to the “origin of the claim” test.  Under this test, any amounts received from a judgment or settlement will be characterized for federal income tax purpose as a substitute payment for the claims or damages the taxpayer asserted or incurred.  Significantly, the origin of the claim test is used to determine whether an amount is taxable or non-taxable and also, if taxable, whether such amount constitutes ordinary income or capital gain.  The origin of the claim test depends on the particular facts.

In many cases, taxpayers will enter into settlement agreements with respect to any injuries asserted prior to or during a lawsuit.  In these instances, the nature of the claim that was the basis for the settlement generally controls whether damages are excludible under I.R.C. § 104(a)(2).  Accordingly, the terms used in the settlement agreement can be significant in determining the origin and allocation of any settlement proceeds for federal tax purposes.  Federal tax attorneys can be invaluable in assisting taxpayers in the drafting of such settlement agreements.

In some cases, however, taxpayers do not enter into settlement agreements and proceed to trial, either by judge or jury.  For example, in PLR 2020500009, a taxpayer-husband was struck by an automobile while riding his bike home from work.  The taxpayer-husband suffered from severe and permanent injuries to his body, which included traumatic brain injuries.  As a result, the taxpayer-husband was in constant pain and suffered from cognitive impairment.  Moreover, taxpayer-husband’s wife also suffered significant loss of consortium due to taxpayer-husband’s injuries.

Taxpayer-husband and taxpayer-wife sued the company who employed the driver.  In the lawsuit, they alleged that the injuries and damages suffered were the result of acts of negligence, recklessness, and willful and wanton acts of the driver.  The lawsuit requested damages for economic injuries (medical bills), for non-economic injuries (mental anguish), loss of enjoyment of life, disability, pain, suffering, and other injuries and damages as well as damages for loss of consortium.

At trial, the jury found the company liable and awarded taxpayer-husband and taxpayer-wife damages for past and future economic damages and for past and future noneconomic damages.  The jury further awarded taxpayer-wife damages for past and future loss of consortium.

On these facts, the IRS held that the taxpayer-husband and taxpayer-wife were not subject to federal income tax on any damages awarded to them under I.R.C. § 104(a)(2).  Specifically, the IRS recognized that the past and future economic and noneconomic damages to taxpayer-husband and the loss of consortium damages to taxpayer-wife were directly attributable and linked to the physical injuries taxpayer-husband had received when the collision occurred.

Freeman Law’s tax attorneys have extensive experience assisting taxpayers with settlement and judgment awards.  For a free consultation on these or any other tax matters, contact us today.

For more insights, see A Primer on the Tax Implications of Settlements and Judgments,

Representation in Tax Audits & Appeals

If you need assistance in managing the audit process, Freeman Law can help taxpayers navigate state tax laws.  We offer value-driven services and provide practical solutions to complex issues. Schedule a consultation or call (214) 984-3410 to discuss our tax representation services.

State Local Tax