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10 Things You Should Know About Plaintiff Recovery Taxation

September 15, 2026

Winning the case doesn’t always mean maximizing the recovery.

The taxation of plaintiff litigation recoveries is widely misunderstood — and the stakes are significant. Here are 10 things every plaintiff and litigation professional should know.

Personal injury lawsuit recoveries are not always tax-free.

Compensatory and emotional distress damages related to physical injuries are generally excluded from income — but punitive damages and interest are not. The nature and origin of the claim, not the label in the complaint or settlement agreement, controls the tax treatment.

Many types of litigation recoveries are taxable, even if there is an injury.

Recoveries for non-physical injuries and related emotional distress, mental anguish, defamation, breach of contract, malpractice, fraud, securities law violations, intellectual property disputes, and many other claims are generally includible in gross income.

Many plaintiffs with taxable recoveries cannot deduct their legal fees.

Personal attorney fees that were once deductible as “miscellaneous itemized deductions” are no longer deductible. IRC §67(g). The One Big Beautiful Bill Act, Pub. L. No. 119-21 (2025), made this suspension permanent. There are limited exceptions — notably, certain employment discrimination and whistleblower cases — but these cover a narrow range of claims. For more details, review this article on settlement and litigation taxation.

The U.S. Supreme Court ruled that plaintiffs are taxed on the attorney-fee portion of their recovery — even though they never receive it.

In Commissioner v. Banks, 543 U.S. 426 (2005), the Supreme Court held that a plaintiff “receives for tax purposes” the attorney-fee portion of a taxable recovery. The consequence: in cases where the attorney fee is not deductible, both the plaintiff and the attorney pay tax on the same dollars. This is referred to as the “attorney-fee double tax.”

In attorney fee double tax situations, plaintiffs in high-tax jurisdictions can end up with little or nothing.

A plaintiff might keep 10% after paying 40% to their lawyer and 50% in Federal, State and Local taxes. And if their attorney had significant expenses not covered by the contingent fee, the plaintiff may end up with close to nothing. In fact, in attorney fee double tax situations, both the government and the lawyers each end up with more than the plaintiff.

Key point

You must address taxes before settlement.

Tax planning to reduce taxes on a recovery is only possible while the case outcome is still “contingent and doubtful.” This means the parties have not yet agreed to any binding settlement terms (e.g., verbally, by email, or a binding mediation term sheet). Careful planning is required as early in the process as possible (see Point 10 below). Once the claim resolves, practically speaking it’s too late.

Defendants face significant penalties if they fail to issue a Form 1099 for the gross settlement amount.

In taxable cases, defendants must report the full recovery — including the portion paid to counsel — to both the plaintiff and the IRS. The penalty for failure to report properly can reach 10% of the unreported amount, without limit. Treas. Reg. §1.6041-1(f); IRC §§6721(e), 6722(e). Assuming a taxable recovery will escape IRS scrutiny is not a realistic strategy.

Plaintiff attorneys have an ethical responsibility to consider client tax issues.

ABA Ethical Guidelines for Settlement Negotiations (August 2002) advise that “competent representation” of plaintiffs requires “considering tax implications of the settlement.” Ethics rules require attorneys to inform clients about the consequences of failing to address taxes or obtain competent tax advice.

Many suggested “workarounds” for the attorney fee double tax don’t work.

Strategies sometimes proposed — such as reporting only the net amount received, treating the attorney-client relationship as a partnership, or excluding structured attorney fees — do not survive IRS scrutiny. These approaches also expose plaintiffs to substantial penalties and interest.

Plaintiffs with taxable recoveries can increase their after-tax recovery — if they act before final resolution of the claim.

One approach is to structure the complaint or settlement agreement with the tax character of the claim in mind, to the extent the underlying facts allow. Another is to transfer the litigation claim into a Plaintiff Recovery Trust (PRT) before settlement. The PRT uses an established charitable trust structure adapted for the litigation context, removing the attorney-fee portion from the plaintiff’s taxable income — so only the amount the plaintiff actually receives is taxed.

See How the Plaintiff Recovery Trust May Reduce the Tax on Your Recovery

Every case is different. Our team is available to review potential planning opportunities — at no obligation — before a recovery becomes definite.

Learn more at PRT.tax Learn about EPTC’s Plaintiff Recovery Trust

Or contact us at recoverytrust@easternpointservices.com

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Frequently Asked Questions

Under IRC § 61, all income from whatever source derived is taxable unless a specific exclusion applies. Lawsuit settlements are included in gross income by default. The key exceptions are physical injury and physical sickness recoveries under IRC § 104(a)(2), which are excluded from gross income when received as compensation for a physical injury or physical sickness claim.

IRC § 104(a)(2) excludes from gross income damages received on account of personal physical injuries or physical sickness. The exclusion applies to compensatory damages only. The injury or sickness must be physical — emotional distress damages, employment discrimination recoveries, breach of contract proceeds, and punitive damages do not qualify for the exclusion and are taxable.

Yes. Punitive damages are taxable as ordinary income regardless of whether the underlying claim involves a physical injury. IRC § 104(a)(2) does not exclude punitive damages. Even in a physical injury case where compensatory damages are excluded, any punitive damages awarded are included in the plaintiff's gross income and subject to federal income tax.

For most plaintiffs, no. The Tax Cuts and Jobs Act of 2017 suspended miscellaneous itemized deductions under IRC § 67(g) for tax years 2018 through 2025, eliminating the attorney fee deduction for most civil litigation recoveries. IRC § 62(a)(20) provides an above-the-line deduction only for qualifying discrimination and whistleblower cases. Plaintiffs in personal injury, breach of contract, and most tort cases cannot deduct attorney fees under current law.

A Qualified Settlement Fund (QSF) under IRC § 468B separates the timing of the defendant's payment from the plaintiff's taxable receipt of funds. The defendant transfers proceeds to the QSF and takes an immediate tax deduction. The plaintiff does not recognize taxable income until distribution from the QSF, preserving a planning window to implement structured settlements, Plaintiff Recovery Trusts, Special Needs Trusts, or other tax-minimization strategies before receiving taxable income.

A Plaintiff Recovery Trust (PRT), administered by Eastern Point Trust Company, addresses the attorney fee double tax created by Commissioner v. Banks, 543 U.S. 426 (2005), and worsened by TCJA 2017. The PRT separates the attorney fee portion of the settlement from the plaintiff's taxable recovery, allowing each party to recognize income only on their respective portion. Eastern Point Trust Company has saved plaintiffs $30 million or more through PRT structures. The PRT is implemented during the QSF administration window before taxable distributions occur.