How to Avoid Paying Taxes on Settlement Money

General Tax Rule for Settlements

The starting point for settlement taxation is IRC Section 61, which states that all income is taxable “from whatever source derived” unless specifically exempted by another provision of the tax code.

This means that settlement payments are presumed taxable unless you can show they qualify for an exception.

The primary exception is IRC Section 104(a)(2), which excludes from gross income “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.”

This exclusion is powerful because it applies to the entire settlement amount for qualifying cases, including compensation for medical expenses, pain and suffering, and even lost wages when those damages arise from physical injury.

The IRS applies what’s called the “origin of the claim” test to determine tax treatment. The central question is: “What was the settlement intended to replace?”

If the settlement replaces something that would have been taxable income (like wages or business profits), the settlement is taxable. If the settlement compensates for personal physical harm, it’s generally not taxable.

The IRS looks at your original complaint, the settlement agreement language, and the facts and circumstances surrounding the case to make this determination.

Note that you must pay taxes on settlement money even if it is earned internationally, such as in an offshore trust.

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Settlement Types That Are Tax-Free

Settlements that qualify under IRC Section 104(a)(2) are completely tax-free, meaning you don’t report them on your tax return, and you owe no federal income tax on the amount received.

For a settlement to qualify, it must be “on account of personal physical injuries or physical sickness.”

Personal physical injury settlements include compensation for car accidents, slip and fall injuries, assault resulting in bodily harm, and medical malpractice that causes physical harm. The IRS requires “observable bodily harm” such as bruises, cuts, swelling, bleeding, broken bones, or diagnosed medical conditions. Pain and suffering arising from these physical injuries is also tax-free, as are medical expenses related to the physical injury.

Workers’ compensation payments for job-related physical injuries are excludable under IRC Section 104(a)(1). Similarly, wrongful death settlements that compensate survivors for the physical injury that caused death are generally tax-free under IRC Section 104(a)(2).

There’s an important exception for medical expense reimbursement. If you previously deducted medical expenses on your tax return and received a tax benefit from that deduction, any settlement reimbursement for those expenses becomes taxable income.

However, if you didn’t deduct the expenses or received no tax benefit, the reimbursement remains tax-free.

One critical point: the 1996 amendment to IRC Section 104(a)(2) added the word “physical” to the statute. Before 1996, emotional distress damages were excludable.

After 1996, only damages for personal physical injuries or physical sickness qualify. This change fundamentally altered settlement taxation and created substantial tax liability for emotional distress claims that would have been tax-free under prior law.

Settlement Types That Are Taxable

Many settlement components are fully taxable as ordinary income, and you’ll typically receive a Form 1099-MISC reporting these amounts to the IRS.

Punitive damages are always taxable regardless of the underlying claim type. Even if you receive punitive damages in a personal physical injury case, those punitive damages are taxable. There’s only a narrow exception for wrongful death cases in states where state law provides only punitive damages as a remedy.

Lost wages and lost profits are taxable as ordinary income because they replace what would have been taxable earnings. Employment-related settlements for back pay, front pay, wrongful termination, and severance are subject to both income tax and employment taxes (Social Security and Medicare taxes). These amounts are typically reported on Form W-2 rather than Form 1099-MISC.

Emotional distress damages are taxable unless the emotional distress is directly attributable to and flows from a personal physical injury or sickness. This distinction matters enormously. If you suffer emotional distress first and then develop physical symptoms (headaches, insomnia, stomach problems), the IRS treats those physical manifestations as “symptoms” of emotional distress, and the entire settlement remains taxable.

However, if you suffer physical injury first and then develop emotional distress as a consequence of that physical injury, both the physical injury damages and the consequential emotional distress damages are tax-free.

Interest on settlements is always taxable as ordinary income, whether it’s pre-judgment or post-judgment interest. Employment discrimination claims for age, race, gender, religion, or disability discrimination are fully taxable. Breach of contract settlements and defamation settlements are generally taxable as ordinary income.

One often-overlooked issue is the taxation of attorney fees. Under the Supreme Court’s decision in Commissioner v. Banks, when a plaintiff has a contingency fee arrangement, the plaintiff must report as income the full settlement amount, including the attorney’s fees. Both the plaintiff and the attorney receive Form 1099-MISC for the full settlement amount.

While some plaintiffs can deduct attorney fees “above the line” under IRC Section 62(a)(20) for employment discrimination and whistleblower cases, many plaintiffs cannot deduct legal fees at all due to the Tax Cuts and Jobs Act’s suspension of miscellaneous itemized deductions through 2025.

Six Ways to Minimize Taxes on Settlement Money

1. Structure Your Settlement Agreement Strategically

The single most important tax planning opportunity occurs before you finalize your settlement agreement.

Once the settlement is signed, you generally cannot change the tax treatment. The IRS gives substantial weight to written allocations in settlement agreements when those allocations are negotiated at arm’s length, made in good faith, and supported by the underlying facts.

In your settlement agreement, clearly allocate the total settlement amount among different damage categories.

For example, in a $200,000 settlement, you might allocate $120,000 to personal physical injuries (tax-free), $50,000 to lost wages (taxable as wages), and $30,000 to emotional distress arising from the physical injury (tax-free). Include specific factual recitals supporting the allocation, such as descriptions of your injuries, medical treatment received, and work time missed.

The key is ensuring your allocations are consistent with your complaint, medical documentation, and the facts of your case. The IRS can challenge allocations that contradict the substance of your claims, but honest allocations based on real facts are typically respected.

2. Use Structured Settlements for Large Recoveries

A structured settlement provides periodic payments over time instead of a lump sum. For personal physical injury cases, structured settlements offer extraordinary tax advantages under IRC Sections 104(a)(2) and 130.

Not only is the principal tax-free, but all the growth and interest earned on the structured settlement is also completely tax-free. With current interest rates around 5% annually, this tax-free compounding can save hundreds of thousands of dollars over a lifetime.

For example, if you receive a $500,000 personal injury settlement and structure it to make annual payments of $40,000 for 20 years, the total payments will exceed $700,000 due to interest, and every dollar is tax-free. In contrast, if you took the $500,000 lump sum and invested it yourself, you’d owe taxes on the investment gains.

Even for taxable settlements (employment discrimination, emotional distress without physical injury), structured settlements provide tax deferral benefits. You spread the income over multiple years, which can keep you in lower tax brackets and reduce your overall tax burden compared to receiving a lump sum in a single year.

3. Maximize Physical Injury Allocations With Medical Documentation

If your case involves any physical component, thoroughly document those physical injuries and allocate the maximum supportable amount to IRC Section 104(a)(2) qualified damages.

The IRS requires “observable bodily harm” for physical injury status, so you need contemporaneous medical records documenting your physical condition.

For example, in an employment discrimination case where your supervisor’s harassment caused severe stress that led to a heart attack requiring hospitalization, you have a strong argument for allocating a significant portion of the settlement to physical injury damages.

The key is to prove the causal link with medical evidence and ensure that your complaint and settlement agreement emphasize the physical injuries.

Physical symptoms alone won’t qualify—you need diagnosed conditions verified by physicians.

A tax court case called Parkinson v. Commissioner distinguished between “symptoms” (subjective evidence perceived by the patient, which remain taxable) and “signs” (objective evidence perceptible to examining physicians, which may qualify as physical injury).

4. Above-the-Line Attorney Fee Deductions

For certain types of claims, you can deduct attorney fees “above the line” on your tax return, meaning you get the deduction even if you don’t itemize.

IRC Section 62(a)(20) allows this deduction for claims of unlawful discrimination, including employment discrimination claims under federal civil rights laws, whistleblower claims, and certain other claims regulating the employment relationship.

The Tax Cuts and Jobs Act eliminated miscellaneous itemized deductions through 2025, making attorney fees non-deductible for most plaintiffs in other types of cases.

If you’re settling an employment discrimination claim for $300,000 and paying $100,000 in attorney fees, you’ll only owe tax on the $200,000 net recovery (assuming you qualify for the above-the-line deduction) rather than on the full $300,000.

Unfortunately, this deduction doesn’t apply to breach of contract claims, defamation cases, or many other non-employment cases. For those plaintiffs, the “double tax” problem remains severe—you’re taxed on money you never received because it went to your attorney.

5. Use Qualified Settlement Funds

A Qualified Settlement Fund (QSF) established under IRC Section 468B provides valuable tax planning flexibility. The defendant deposits the settlement funds into a court-supervised fund, receives an immediate tax deduction, and gains full release from the case.

Meanwhile, you defer constructive receipt of the settlement, which means no taxable event occurs until the QSF actually distributes funds to you.

This timing flexibility allows you to spread receipts between tax years, establish special needs trusts, negotiate Medicare or Medicaid liens, and arrange structured settlements without pressure. For example, if you settle a case in December 2025 but want to defer the tax impact until 2026, a QSF allows the defendant to close out the case while you delay receiving the funds until January 2026.

QSFs are particularly useful for complex cases with multiple claimants, minor plaintiffs requiring court approval, or situations requiring time to resolve healthcare liens that would otherwise reduce your net recovery.

6. Understand State Tax Obligations

Don’t forget state taxes when planning your settlement.

While most states follow federal rules and exempt personal physical injury settlements from taxation, state treatment of other settlement types varies.

Nine states have no income tax at all (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming), meaning you keep 100% of your settlement after federal taxes.

High-tax states can significantly reduce your net recovery. In some cases, particularly in New Jersey, the state doesn’t allow the above-the-line deduction for attorney fees even though federal law does, creating additional state-level double taxation.

If you’re settling a large taxable claim and have flexibility about where you reside, establishing legitimate residency in a no-income-tax state before settlement could save tens of thousands of dollars. However, this requires genuine relocation with objective evidence.

States aggressively audit taxpayers who claim to have moved just before receiving large settlements.

The Critical Importance of Settlement Agreement Language

Settlement language directly determines your tax treatment. The IRS will examine your settlement agreement when determining whether payments qualify for exclusion under IRC Section 104(a)(2).

Your settlement agreement should include specific language describing the nature of the damages being compensated, factual recitals supporting the allocation, and clear statements of intent regarding tax treatment.

For example, rather than simply stating “general damages,” use language like “$150,000 for personal physical injuries sustained in the accident of June 15, 2024, including broken arm, concussion, and related medical treatment, which qualify for exclusion under IRC Section 104(a)(2) as documented in attached medical records.”

If attorney fees are being paid, specify whether they’re being paid directly to your attorney or to you, and clarify the tax reporting. Include language prohibiting the defendant from issuing Form 1099-MISC for amounts allocated to excludable physical injury damages. These provisions protect you from incorrect tax reporting that would trigger IRS inquiries.

The deadline for optimal tax planning is before the settlement is finalized. Once you sign the agreement and cash the check, the IRS generally won’t allow you to recharacterize the settlement components.

Work with both your personal injury attorney and a tax professional before finalizing settlement terms to ensure the agreement is drafted to minimize your tax liability within the bounds of the law and the facts of your case.