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The Impact of Legal Settlements on Tax Liability


Legal settlements can be a windfall for plaintiffs, a necessary expense for defendants, and a significant achievement for attorneys. However, these settlements often come with intricate tax implications that can influence the net amount received or paid. This article will explore the various tax responsibilities associated with different types of legal settlements.


1. Personal Injury Awards

Tax Benefits:

  • Generally Tax-Free: Damages received due to personal physical injuries or physical sickness are typically not taxable. This includes both the amounts awarded for the injury itself and any additional amounts for emotional distress caused by the physical injury.

Drawbacks:

  • Taxation on Interest and Punitive Damages: While the core personal injury settlement might be tax-free, interest on the settlement and any punitive damages are taxable.

2. Employment Settlements

Tax Benefits:

  • Certain Deductions: Employers can often deduct attorney fees and costs associated with employment claims, regardless of whether they win or lose the case.

Drawbacks:

  • Taxable to Employees: Most components of employment settlements, such as back pay or compensatory damages, are taxable to the employee. They're also subject to employment taxes.

  • Non-Physical Injury Claims: Emotional distress claims that aren't due to a physical injury or sickness are taxable.

3. Property Damage Settlements

Tax Benefits:

  • Capital Gains Treatment: If property damage leads to a settlement that exceeds the property's adjusted basis, the excess can be treated as a capital gain, potentially qualifying for lower tax rates.

Drawbacks:

  • Possible Income Recognition: If the settlement exceeds the property's adjusted basis but doesn't lead to a complete destruction of the property, the excess might need to be reported as ordinary income.

4. Class Action Settlements

Tax Benefits:

  • Possible Exclusions: Some parts of class action settlements might not be considered income and thus are non-taxable, depending on the specifics of the case.

Drawbacks:

  • Varied Tax Treatment: Class action settlements can encompass a variety of claims, each with its tax implications. Components like interest, punitive damages, or non-physical injuries are typically taxable.

5. Divorce Settlements

Tax Benefits:

  • Non-Taxable Transfers: Transfers of property between spouses or incident to a divorce are usually not taxable events.

Drawbacks:

  • Alimony Changes: As of recent tax law changes, alimony is no longer deductible by the payer and is no longer taxable income for the recipient for divorce agreements made or modified after December 31, 2018.


The tax implications of legal settlements are multifaceted and largely dependent on the nature of the claim and the specifics of the settlement agreement. Attorneys should be aware of these nuances to provide comprehensive advice to their clients. As with all matters of taxation, consulting with a tax professional is crucial to navigate the complexities and ensure compliance with tax laws.

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