An educational reference on how federal income tax applies to litigation settlement and judgment proceeds, with an orientation, FAQ, charts by treatment and by claim type, and a full disclosure.
Educational purposes only. Eastern Point Trust Company publishes this material for educational purposes only. It is not legal, tax, accounting, or investment advice. Readers should verify the treatment of any settlement with experienced tax counsel or a certified public accountant before acting. The full Disclosure and Acknowledgment appears at the end of this page.
A Practical Orientation
This document answers one question in many forms: when a person receives money to settle a dispute or satisfy a judgment, how much of it is subject to federal income tax. The orientation and the questions that follow are written for general readers. The charts and analysis in the reference section that follows are written for advisors who need the supporting authority. A reader who understands the points below has most of what a settlement recipient needs.
The one question that drives the answer
Federal tax law treats almost everything as income unless a specific rule says otherwise. For a settlement, the controlling question is what the money was meant to replace. Money that replaces a physical injury is generally tax-free. Money that replaces lost wages, lost profits, or a non-physical harm such as damage to reputation is generally taxable. Money that returns the cost of damaged or lost property is not income up to what the owner had invested. The label on a claim matters far less than the nature of the harm behind it.
Timing changes the result
The tax character of a recovery is set by the claims actually asserted and the facts behind them, not by language added at the end. Decisions made before a complaint is filed, and again before a settlement agreement is signed, shape the tax outcome. Waiting until the money is in hand forecloses most planning. Interest is the common surprise: interest on an award is taxable even when the award itself is tax-free, and it grows the longer a case runs.
How to get the best result
Three habits protect a recipient. Plead the claims with specificity, so the record reflects the real nature of the harm. Allocate the settlement among claims in the agreement, supported by the pleadings and the negotiating history, rather than after the fact. Bring in tax counsel before signing, while allocation, structure, and fee arrangements can still be shaped. A structured settlement or a qualified settlement fund can defer or smooth taxable amounts when designed correctly.
When to involve tax counsel
Certain matters should not be resolved on a staff member’s reading of a chart. Get tax counsel involved when the claimant is a business or a closely held entity; when a recovery mixes physical-injury and non-physical components; when interest is a large share of the recovery; when attorney fees are court-awarded or shifted by statute; and whenever a payment comes from a governmental program or a statutory restitution scheme, because the tax result then depends on the enabling statute and cannot be inferred from the identity of the payor or the sympathetic nature of the claim.
What this document does not do
This material covers federal income tax only. It does not address state or local tax, which can differ. It addresses the recipient’s tax, not the payor’s deduction. It is educational and is not legal or tax advice, and it is not a substitute for analysis of a specific matter. The catalogue of claims is broad but not exhaustive, and the omission of a claim type says nothing about whether a recovery is taxable. Every general rule here yields to the facts of the particular case.
Frequently Asked Questions
Is my settlement taxable?
Start from the assumption that it is, then look for an exclusion. The principal exclusion is for damages that compensate a personal physical injury or physical sickness. Recoveries that replace wages, profits, or a non-physical harm are generally taxable. IRC §§ 61, 104(a)(2).
My case was for a physical injury. Do I owe tax on any of it?
The compensatory part, including pain and suffering and the emotional distress that flows from the injury, is generally tax-free. Two pieces are still taxable: punitive damages and any interest on the award.
What is the difference between a physical injury and emotional distress for tax purposes?
Damages for a physical injury or physical sickness are excludable. Damages for emotional distress that does not arise from a physical injury are taxable, except for the part that reimburses the cost of medical care for that distress. The boundary is heavily litigated and turns on the medical facts and the pleadings. IRC § 104(a); Rev. Rul. 96-65.
Are punitive damages ever tax-free?
As a rule, no. Punitive damages are taxable even in a physical-injury case. The narrow exception is a wrongful death claim in a state whose law as of September 1995 allowed only punitive damages. IRC § 104(a)(2), (c); O’Gilvie v. United States, 519 U.S. 79 (1996).
Why is the interest on my award taxable when the award itself is not?
Interest compensates for the delay in payment, not for the injury, so it is treated as ordinary interest income regardless of how the underlying award is taxed. On an older case the interest can be a large share of the total. Kovacs v. Commissioner, 100 T.C. 124 (1993); Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996).
The settlement agreement allocates the money among claims. Will the IRS respect that?
An allocation negotiated at arm’s length and consistent with the pleadings and the record is generally respected. An allocation invented after the fact, or one that contradicts the complaint, invites the IRS to disregard it and tax the recovery by the claims as actually pled. Rev. Rul. 85-98.
Can I deduct my attorney’s fees?
For most taxable recoveries the claimant’s income includes the full amount, including the contingent fee paid to the lawyer. An above-the-line deduction for the fee is available for claims of unlawful discrimination, employment claims, False Claims Act claims, and listed whistleblower awards. Outside those categories the fee is often not deductible, so the claimant can be taxed on the gross recovery. Commissioner v. Banks, 543 U.S. 426 (2005); IRC § 62(a)(20), (21).
Someone told me any claim can be recast as a civil rights claim to capture the fee deduction. Is that right?
No. The deduction requires a real claim of unlawful discrimination: the claimant must have been a victim of it, it must be pled with specificity, and the defendant must have agreed to settle that claim. Recasting an unrelated claim as a civil rights claim to capture the deduction is improper and invites denial and penalties. See the Caution in the reference section.
Should I think about taxes before or after settling?
Before, and ideally before the complaint is even filed. The tax character is built into the claims and the record; it cannot be added later by the settlement agreement. The most valuable planning happens before signing.
Does it matter that I am settling with a city or a government agency?
The identity of the payor does not by itself make a recovery tax-free. A civil rights recovery without physical injury is taxable whether the defendant is a private party or a government. Payments under specific statutory programs follow their own rules and should be checked against the governing statute.
My recovery is for damage to my property. Is that income?
A recovery for damaged or destroyed property is treated as a return of what was invested. It is not income up to the property’s adjusted basis, and it reduces that basis. Only the amount above basis is taxable, and a reinvestment rule may defer even that. IRC § 1033.
I received money from a settlement fund. When am I taxed?
A qualified settlement fund is itself a taxpayer on its investment earnings. The claimant is generally taxed when the fund distributes the money, according to the character of the underlying claim. IRC § 468B.
Is this document tax advice?
No. It is general educational material. The taxation of a settlement depends on facts specific to the matter, and a recipient should confirm the treatment with experienced tax counsel or a certified public accountant before acting.
What about my state taxes?
State and local tax is outside the scope of this document. Most states follow the federal treatment, but some states, municipalities, and localities tax portions of a settlement differently. Verify state and local treatment with a qualified advisor.
Reference: Detailed Tax Treatment
Framework, charts, and authorities for advisors. The orientation and FAQ above cover the practical essentials.
The Governing Framework
Federal law starts from inclusion. Section 61 of the Internal Revenue Code defines gross income as all income from whatever source derived, and the Supreme Court reads that language to reach every undeniable accession to wealth, clearly realized, over which the taxpayer has complete dominion. IRC § 61; Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). A litigation recovery is therefore taxable unless a specific statutory exclusion removes it from gross income.
The analysis of any settlement or judgment proceeds in three steps.
Step One
Inclusion is the default
Section 61 presumptively taxes the recovery. The burden rests on the recipient to identify an exclusion.
Step Two
Origin of the claim
The recovery takes the tax character of the claim it resolves. The controlling question is what the payment was intended to replace: lost wages, lost profits, injured capital, or an injured person.
Step Three
Apply the exclusions
Section 104(a)(2) excludes damages, other than punitive damages, received on account of personal physical injuries or physical sickness. Narrower exclusions cover workers’ compensation, certain insurance recoveries, wrongful incarceration, and specific statutory programs.
Section 104(a)(2) excludes damages, other than punitive damages, received on account of personal physical injuries or physical sickness. Narrower exclusions cover workers’ compensation, certain insurance recoveries, wrongful incarceration, and specific statutory programs.
Section 104(a)(2) applies whether the recovery comes by suit or agreement and whether it is paid as a lump sum or as periodic payments. IRC § 104(a)(2). Two statutory limits define its edges. First, punitive damages are carved out of the exclusion. IRC § 104(a)(2); O’Gilvie v. United States, 519 U.S. 79 (1996). Second, emotional distress is not treated as a physical injury or physical sickness, except for damages up to the amount paid for medical care attributable to that distress. IRC § 104(a), flush language.
Allocation matters. Where a settlement resolves several claims, an express allocation in the settlement agreement is generally respected if it is consistent with the substance of the settled claims; an allocation drafted after the fact, or one inconsistent with the pleadings and the record, invites recharacterization. Rev. Rul. 85-98, 1985-2 C.B. 51.
Chart 1: Settlement Proceeds Organized by Tax Treatment
Excludable generally not taxed Taxable generally taxed Mixed treatment depends on facts or allocation
Section A. Generally Non-Taxable Settlement Proceeds
Proceeds generally excludable from gross income
| Category |
Treatment and Caveats |
Principal Authority |
| Compensatory damages for personal physical injury or physical sickness |
The entire compensatory recovery is excludable, including pain and suffering, emotional distress attributable to the physical injury, and lost wages flowing from the injury. Punitive damages and interest remain taxable. Covers auto accidents, medical malpractice, premises liability, products liability, and physical assault. |
IRC § 104(a)(2); Rev. Rul. 85-97, 1985-2 C.B. 50 |
| Medical expense recoveries |
Excludable, except amounts attributable to medical expense deductions taken in a prior year, which are recaptured under the tax benefit principle stated in the statute’s opening clause. |
IRC § 104(a) (lead-in); IRC § 213 |
| Emotional distress damages, medical-cost portion |
Where no physical injury exists, damages remain excludable up to the amount actually paid for medical care attributable to the emotional distress. Amounts above that ceiling are taxable. |
IRC § 104(a), flush language |
| Workers’ compensation |
Amounts received under workers’ compensation acts for occupational injury or sickness are excludable. The exclusion does not cover retirement pensions measured by age, length of service, or prior contributions. |
IRC § 104(a)(1); Treas. Reg. § 1.104-1(b) |
| Wrongful death, compensatory damages |
Compensatory wrongful death recoveries are excludable as damages on account of physical injury. Punitive damages are taxable, except where governing state law as of September 13, 1995 provided only punitive damages for wrongful death. |
IRC § 104(a)(2); IRC § 104(c); Burford v. United States, 642 F. Supp. 635 (N.D. Ala. 1986) |
| Loss of consortium |
Excludable when derivative of a family member’s physical injury. The wrongful incarceration exclusion, by contrast, does not extend to derivative family claims. |
IRC § 104(a)(2); IRS FS-2023-26 (§ 139F FAQ) |
| Accident and health insurance proceeds |
Excludable for personal injuries or sickness, subject to limits where the employer paid or contributed to the coverage on a pre-tax basis. |
IRC § 104(a)(3) |
| Life insurance death benefits |
Proceeds paid by reason of the insured’s death are excludable, including when paid in settlement of a coverage dispute; interest on delayed or installment payments is taxable. |
IRC § 101(a), (c); Treas. Reg. § 1.101-1 |
| Inheritance-character recoveries (will contests) |
Amounts an heir or beneficiary receives in settlement of a will contest take the character of an inheritance and are excludable from gross income. |
IRC § 102(a); Lyeth v. Hoey, 305 U.S. 188 (1938); Treas. Reg. § 1.102-1(a) |
| Wrongful incarceration awards |
Civil damages, restitution, or other monetary awards relating to incarceration for a covered offense are excludable for the wrongfully incarcerated individual. Settlements qualify. See Special Circumstances for eligibility limits. |
IRC § 139F; IRS FS-2023-26 |
| Property damage recoveries, up to basis |
A recovery for damage to or loss of property is a return of capital up to the owner’s adjusted basis and is not income; it reduces basis. Any excess over basis is taxable gain, possibly eligible for involuntary conversion deferral if reinvested. |
Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110 (1st Cir.), cert. denied, 323 U.S. 779 (1944); IRC § 1033 |
| Qualified disaster relief payments |
Payments to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster are excludable. |
IRC § 139 |
| Public safety officer survivor payments |
Federal death benefits and qualifying state program payments to surviving dependents of public safety officers killed in the line of duty are excludable. |
IRC § 104(a)(6) |
Section B. Generally Taxable Settlement Proceeds
Proceeds generally includable in gross income| Category | Treatment and Caveats | Principal Authority |
|---|
| Punitive damages | Taxable as ordinary income even when awarded in a physical injury case. The single exception is the wrongful death rule of § 104(c). | IRC § 104(a)(2); O’Gilvie v. United States, 519 U.S. 79 (1996) |
|---|
| Pre-judgment and post-judgment interest | Taxable as ordinary interest income in all cases, including where the underlying award is fully excludable as physical injury damages. Courts treat interest as compensation for delay in payment, not as damages on account of injury. | Kovacs v. Commissioner, 100 T.C. 124 (1993), aff’d (6th Cir. 1994); Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996); Rozpad v. Commissioner, 154 F.3d 1 (1st Cir. 1998); Chamberlain v. United States, 401 F.3d 335 (5th Cir. 2005) |
|---|
| Emotional distress without physical injury | Taxable, except for the medical-cost portion noted in Section A. Distress caused by a physical injury remains excludable; physical symptoms caused by distress generally do not convert the claim. The line is heavily litigated and fact-specific. | IRC § 104(a), flush language; Rev. Rul. 96-65, 1996-2 C.B. 6 |
|---|
| Employment recoveries: back pay, front pay, severance | Taxable as ordinary income. Amounts replacing wages are wages for employment tax and withholding purposes regardless of the label the parties use. | Rev. Rul. 96-65; Social Security Bd. v. Nierotko, 327 U.S. 358 (1946) |
|---|
| Discrimination recoveries (Title VII, ADEA, ADA) absent physical injury | Taxable. The Supreme Court requires both a tort-like personal injury claim and damages received on account of physical injury or sickness; discrimination recoveries standing alone satisfy neither. An above-the-line attorney fee deduction is generally available; see Special Circumstances. | Commissioner v. Schleier, 515 U.S. 323 (1995); IRC § 62(a)(20), (e) |
|---|
| Defamation, libel, slander; invasion of privacy | Taxable. Injuries to reputation and privacy are non-physical under the post-1996 statute. | IRC § 104(a)(2) (as amended 1996) |
|---|
| Breach of contract, fraud, and other economic torts | Taxable per the origin of the claim. Where the recovery replaces injured capital (for example, a defrauded investment), it is first a non-taxable return of basis, with only the excess taxed; character as ordinary or capital follows the underlying asset. | IRC § 61; Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110 (1st Cir. 1944) |
|---|
| Lost profits and lost business income | Taxable as ordinary income, because the profits replaced would have been ordinary income. | Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110 (1st Cir. 1944) |
|---|
| Statutory damages (consumer protection and similar) | Taxable. Per-violation awards under statutes such as the FCRA, FDCPA, and TCPA, and statutory damages under the Copyright Act, are accessions to wealth with no applicable exclusion. | IRC § 61; Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) |
|---|
| Statutory treble and multiple damages | Taxable. The Supreme Court held the punitive two-thirds of a treble damage antitrust recovery to be gross income; the compensatory third is taxed by its own origin (lost profits are ordinary income). | Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) |
|---|
| Whistleblower awards | Taxable. Relator shares under the False Claims Act and awards under the IRS, SEC, and CFTC programs are ordinary income; an above-the-line attorney fee deduction generally applies. | IRC § 61; IRC § 62(a)(20), (21) |
|---|
| Insurance bad faith | Generally taxable. The claim sounds in contract or economic tort against the insurer and is distinct from any underlying physical injury claim. | IRC § 61 (origin of the claim) |
|---|
Section C. Unique or Special Circumstances
Situations requiring separate analysis| Circumstance | Treatment and Caveats | Principal Authority |
|---|
| Attorney’s fees in taxable recoveries | A claimant’s gross income includes the full recovery, including the contingent fee paid to counsel. Claims of unlawful discrimination (broadly defined), False Claims Act claims, and listed whistleblower awards carry an above-the-line deduction for fees, capped at the income included from the claim. For taxable claims outside those categories, miscellaneous itemized deductions remain suspended, and the claimant may owe tax on the gross recovery. | Commissioner v. Banks, 543 U.S. 426 (2005); IRC § 62(a)(20), (21), (e); IRC § 67(g) |
|---|
| Sexual harassment settlements with nondisclosure terms | Section 162(q) denies the payor’s deduction where the settlement is subject to a nondisclosure agreement. The IRS confirms the rule does not bar the recipient from deducting attorney’s fees that are otherwise deductible. | IRC § 162(q); IRS Section 162(q) FAQ |
|---|
| Structured settlements (periodic payments) | Excludable physical injury damages remain excludable when paid as periodic payments, including the growth embedded in the payment stream. A defendant, insurer, or qualified settlement fund may transfer the payment obligation through a qualified assignment. For taxable claims, a properly designed non-qualified structure defers recognition until payments are received. | IRC § 104(a)(2); IRC § 130; Rev. Proc. 93-34, 1993-2 C.B. 470 |
|---|
| Qualified settlement funds | A QSF under § 468B is a separate taxpayer taxed on its modified gross income (generally its investment earnings, not the settlement corpus). The claimant is taxed, if at all, when distributions are received, according to the character of the underlying claim. A QSF is treated as a party to the suit for qualified assignment purposes. | IRC § 468B; Treas. Reg. § 1.468B-2; Rev. Proc. 93-34 |
|---|
| Wrongful incarceration: eligibility limits | The § 139F exclusion requires a conviction for a covered offense, service of all or part of a sentence, and a qualifying pardon, reversal, or dismissal grounded in innocence. Settlement payments qualify as civil damages. Derivative family claims (loss of consortium or companionship) do not qualify, and restored military pay following reversal of a court martial is not excludable. | IRC § 139F; IRS FS-2023-26 |
|---|
| Settlements with municipalities and governmental entities | No general exclusion applies merely because the payor is a government. Civil rights recoveries under 42 U.S.C. § 1983 are taxable absent physical injury. State exoneration statute payments fall within § 139F when its elements are met. Program-specific payments (disaster relief, victim compensation, public safety officer benefits) depend on their own statutes. | IRC §§ 61, 104(a)(2), 139, 139F, 104(a)(6) |
|---|
| Tax benefit recapture | Recovery of amounts deducted in a prior year (typically medical expenses) is taxable to the extent the earlier deduction produced a tax benefit. | IRC § 104(a) (lead-in); IRC § 111 |
|---|
| Divorce-related payments | Property transfers incident to divorce are nonrecognition events with carryover basis. Alimony under instruments executed after December 31, 2018 is not income to the recipient; pre-2019 instruments remain taxable to the recipient absent modification. Child support is never income. | IRC § 1041; Tax Cuts and Jobs Act of 2017 |
|---|
| Reporting and withholding | Wage-replacement amounts are reported on Form W-2 with employment tax withholding. Other taxable amounts are generally reported on Form 1099. Fully excludable physical injury proceeds are generally not subject to information reporting. Labels in the agreement do not control; substance does. | Rev. Rul. 96-65; Social Security Bd. v. Nierotko, 327 U.S. 358 (1946) |
|---|
Chart 2: Litigation Claims by Type, Alphabetical
The chart below summarizes the general federal income tax treatment of settlement proceeds for individual claimants, by type of claim. Each entry assumes a compensatory recovery; punitive damages and interest are taxable in every category. The treatment shown is the general rule; allocation, pleading, and the facts of the particular case can change the result.
Excludable generally not taxed Taxable generally taxed Mixed treatment depends on facts or allocation
Individual claimants: claim types A through W
| Claim Type |
Treatment |
Summary and Caveats |
Principal Authority |
| Age discrimination (ADEA) |
Taxable |
No physical injury; back pay and liquidated damages includable. Above-the-line fee deduction available. |
Commissioner v. Schleier, 515 U.S. 323 (1995); IRC § 62(a)(20) |
| Assault and battery (physical) |
Excludable |
Compensatory damages for the physical injury, including resulting emotional distress, are excludable. |
IRC § 104(a)(2) |
| Auto accident / negligence |
Excludable |
Full compensatory recovery excludable, including lost wages attributable to the injury. |
IRC § 104(a)(2); Rev. Rul. 85-97 |
| Breach of contract |
Taxable |
Taxable per origin; recovery of injured capital is first a return of basis. |
IRC § 61; Raytheon Prod. Corp., 144 F.2d 110 (1st Cir. 1944) |
| Breach of fiduciary duty |
Mixed |
Character follows the harm: lost income is ordinary; injury to an investment is basis recovery, then gain. |
IRC § 61 (origin of the claim) |
| Civil RICO |
Taxable |
Treble recoveries for economic injury are ordinary income; the multiplied portion is taxable in all events. Basis recovery applies where the injury is to capital. |
IRC § 61; Glenshaw Glass, 348 U.S. 426 (1955) |
| Civil rights (42 U.S.C. § 1983); police misconduct |
Mixed |
Police misconduct, excessive force, and other § 1983 claims are mixed: a recovery for personal physical injury qualifies for exclusion, while a recovery for a non-physical violation (wrongful arrest, due-process, First Amendment) is taxable. Pre- and post-judgment interest is taxable even where the underlying award is excludable. Fee deduction often available. |
IRC § 104(a)(2); IRC § 62(a)(20), (e)(13) |
| Consumer overcharge / price-fixing refunds |
Mixed |
Refunds of amounts paid for personal-use goods and services operate as purchase price adjustments rather than income, absent a prior deduction or other tax benefit; amounts beyond the price paid, and interest, are taxable. |
IRC § 61 (origin of the claim) |
| Crime victim restitution and compensation |
Mixed |
Restitution and victim compensation payments for physical injury take the § 104(a)(2) exclusion; restitution of stolen or destroyed property is a return of capital up to basis; amounts replacing income are taxable. |
IRC § 104(a)(2); Raytheon Prod. Corp., 144 F.2d 110 (1st Cir. 1944) |
| Data breach / privacy class actions |
Mixed |
Payments reimbursing documented out-of-pocket loss operate as a return of capital; flat payments without a showing of loss are accessions to wealth. The area is developing; documentation of loss matters. |
IRC § 61; Glenshaw Glass, 348 U.S. 426 (1955) |
| Defamation (libel, slander) |
Taxable |
Reputational injury is non-physical under the post-1996 statute. |
IRC § 104(a)(2) (as amended 1996) |
| Disability discrimination (ADA) |
Taxable |
Taxable absent physical injury; wage portions subject to employment tax. Fee deduction available. |
Schleier; Rev. Rul. 96-65; IRC § 62(a)(20) |
| Disability, health, and ERISA benefit disputes |
Mixed |
Recovered disability benefits are excludable where the claimant paid the premiums with after-tax dollars and taxable where the employer paid them on a pre-tax basis; recovered medical-expense benefits are generally excludable; character follows the benefit the recovery replaces. |
IRC §§ 104(a)(3), 105(a); Rev. Rul. 2004-55, 2004-1 C.B. 1 |
| Divorce and marital settlement payments |
Mixed |
Property transfers incident to divorce are nonrecognition events with carryover basis; alimony under instruments executed after 2018 is not income to the recipient (pre-2019 instruments remain taxable to the recipient absent modification); child support is never income. |
IRC § 1041; Tax Cuts and Jobs Act of 2017 |
| Elder financial abuse |
Mixed |
Recovery of misappropriated funds or property is a return of capital up to basis; amounts above basis, interest, and punitive damages are taxable; physical injury components follow the § 104 rules. |
IRC § 61; Raytheon Prod. Corp., 144 F.2d 110 (1st Cir. 1944) |
| Eminent domain / inverse condemnation |
Mixed |
Condemnation proceeds are treated as proceeds of a sale: return of basis, then gain, with elective deferral where qualifying replacement property is acquired; severance damages reduce basis in the retained property; interest is taxable. |
IRC §§ 1001, 1033 |
| Emotional distress (standalone) |
Taxable |
Taxable except up to amounts paid for related medical care. |
IRC § 104(a), flush language |
| Employment discrimination (Title VII) |
Taxable |
Back pay and emotional distress damages includable; back pay is wages. Fee deduction available. |
Rev. Rul. 96-65; IRC § 62(a)(20) |
| Fair housing discrimination (FHA) |
Taxable |
Damages for housing discrimination, including emotional distress, are taxable absent physical injury; fees may be deductible above the line under the § 62(e)(15) listing. |
IRC § 104(a)(2); IRC § 62(a)(20), (e)(15) |
| False arrest / false imprisonment |
Mixed |
Generally taxable absent physical injury. Where the claimant was convicted and incarcerated and the § 139F elements are met, the recovery is excludable. |
IRC § 104(a)(2); IRC § 139F |
| False Claims Act (qui tam relator share) |
Taxable |
Relator share is ordinary income; above-the-line fee deduction applies to FCA claims. |
IRC § 61; IRC § 62(a)(20) |
| FCRA / FDCPA / TCPA consumer claims |
Taxable |
Statutory and actual damages includable; no exclusion applies. |
IRC § 61; Glenshaw Glass, 348 U.S. 426 (1955) |
| Federal compensation programs (VICP, VCF, Camp Lejeune) |
Excludable |
Awards compensating physical injury or physical sickness, including vaccine injury compensation and Camp Lejeune Justice Act recoveries, take the § 104(a)(2) exclusion; prior medical deductions are recaptured and any punitive or interest components are taxable. Each program should be verified on its own terms. |
IRC § 104(a)(2) |
| Fraud / misrepresentation (investment) |
Mixed |
Return of basis first; excess is gain, with character following the underlying asset. |
Raytheon Prod. Corp., 144 F.2d 110 (1st Cir. 1944) |
| Insurance bad faith |
Taxable |
Contract-based claim against the insurer; taxable independent of any underlying injury claim. |
IRC § 61 (origin of the claim) |
| Intellectual property and intangible-property claims |
Mixed |
Copyright, patent, trademark, trade secret, and licensing recoveries are analyzed by origin: amounts replacing royalties or lost profits are ordinary income; amounts for the sale, taking, or destruction of the IP asset itself can be capital, recovered against basis. Right-of-publicity and name-image-likeness recoveries appear separately below. Business-held IP is addressed in the business-entity section. |
IRC § 61 (origin of the claim) |
| Invasion of privacy |
Taxable |
Non-physical injury; no exclusion applies. |
IRC § 104(a)(2) (as amended 1996) |
| Landlord-tenant disputes |
Mixed |
Security deposit recoveries and rent refunds for personal housing operate as a return of amounts paid; wrongful eviction and harassment damages are taxable absent physical injury; relocation payments depend on the authorizing program. |
IRC §§ 61, 104(a)(2) |
| Legal malpractice |
Mixed |
Origin of the claim controls; courts have reached differing results where the recovery replaces an excludable personal injury award. Fact-specific; advice required. |
IRC § 61 (origin of the claim) |
| Life insurance benefit disputes |
Excludable |
Proceeds paid by reason of the death of the insured retain the § 101(a) exclusion when recovered through a coverage dispute; interest on delayed or installment proceeds is taxable under § 101(c). |
IRC § 101(a), (c); Treas. Reg. § 1.101-1 |
| Loss of consortium |
Excludable |
Excludable as derivative of a family member’s physical injury. Not excludable when derivative of wrongful incarceration. |
IRC § 104(a)(2); IRS FS-2023-26 |
| Malicious prosecution / abuse of process |
Taxable |
Dignitary torts without physical injury are taxable; the same rule reaches surviving heart-balm torts such as alienation of affections. |
IRC § 104(a)(2) (as amended 1996) |
| Medical malpractice |
Excludable |
Compensatory damages excludable; punitive damages and interest taxable. |
IRC § 104(a)(2) |
| Nuisance (private) |
Mixed |
Recoveries for diminished property value reduce basis, with the excess taxed as gain; annoyance and discomfort damages are taxable unless tied to physical sickness. |
IRC § 61; Raytheon Prod. Corp., 144 F.2d 110 (1st Cir. 1944) |
| Personal physical injury (general tort) |
Excludable |
Entire compensatory recovery excludable, including the lost wage component. |
IRC § 104(a)(2); Rev. Rul. 85-97 |
| Premises liability (slip and fall) |
Excludable |
Compensatory damages for the physical injury excludable. |
IRC § 104(a)(2) |
| Products liability |
Excludable |
Compensatory damages for physical injury or physical sickness excludable. |
IRC § 104(a)(2) |
| Property damage |
Mixed |
Return of capital up to adjusted basis; excess is taxable gain, with possible § 1033 deferral on reinvestment. |
Raytheon Prod. Corp.; IRC § 1033 |
| Reparations and statutory restitution programs |
Mixed |
Several reparations and restitution programs have been enacted with express statutory exclusions, while others produce taxable payments; the enabling act controls, and each program must be verified on its own terms. |
Program-specific statutes; IRC § 61 |
| Right of publicity / name, image, and likeness |
Taxable |
Recoveries for unauthorized commercial use of name, image, or likeness generally replace licensing income and are ordinary income; capital treatment is rare and fact-dependent. |
IRC § 61 (origin of the claim) |
| Securities fraud |
Mixed |
Recovery generally reduces basis in the securities or produces gain; held-asset versus disposed-asset facts matter. |
IRC § 61 (origin of the claim) |
| Sexual abuse / sexual assault |
Mixed |
Recoveries involving physical injury are excludable. Where no observable bodily harm exists, the analysis is fact-specific and the IRS has applied the physical injury requirement restrictively. The payor-side nondisclosure rule of § 162(q) does not affect the recipient’s fee deduction. |
IRC § 104(a)(2); IRC § 162(q); IRS Section 162(q) FAQ |
| Sexual harassment (workplace) |
Taxable |
Taxable absent physical injury; wage components are wages for employment tax purposes. Section 162(q) limits the payor’s deduction where a nondisclosure agreement applies but does not bar the recipient’s fee deduction. |
Rev. Rul. 96-65; IRC §§ 62(a)(20), 162(q) |
| Toxic tort / environmental exposure |
Mixed |
Excludable where the claimant demonstrates physical sickness from the exposure; recoveries for fear of future illness or medical monitoring without present sickness are weaker cases for exclusion. |
IRC § 104(a)(2) |
| Trust and estate fiduciary disputes |
Mixed |
A beneficiary’s recovery takes the character of what it replaces: restored corpus is not income, replaced trust income is taxable, and surcharge recoveries follow the origin of the injury; recoveries in lieu of an inheritance can take inheritance character. |
Lyeth v. Hoey, 305 U.S. 188 (1938); IRC § 102 |
| Wage and hour (FLSA, state wage laws) |
Taxable |
Recovered wages, overtime, and liquidated damages are ordinary income; wage portions are subject to employment tax and withholding. Fees deduct above the line under the § 62(e)(4) listing. |
Rev. Rul. 96-65; IRC § 62(e)(4) |
| Whistleblower awards (IRS, SEC, CFTC) |
Taxable |
Ordinary income; above-the-line fee deduction under § 62(a)(21). |
IRC § 61; IRC § 62(a)(21) |
| Will contests and inheritance disputes |
Excludable |
Amounts an heir or beneficiary receives in settlement of a will contest take the character of an inheritance and are excludable; amounts received as compensation for services to the decedent, or as replaced income, remain taxable. |
Lyeth v. Hoey, 305 U.S. 188 (1938); IRC § 102(a); Treas. Reg. § 1.102-1(a) |
| Workers’ compensation |
Excludable |
Excludable for occupational injury or sickness; pension-like amounts excluded from the exclusion. |
IRC § 104(a)(1); Treas. Reg. § 1.104-1(b) |
| Wrongful birth / wrongful conception |
Mixed |
Recoveries tied to the physical injuries of pregnancy and childbirth support exclusion; components compensating child-rearing costs or emotional distress without physical injury are weaker cases. Fact-specific; advice required. |
IRC § 104(a)(2) |
| Wrongful death |
Excludable |
Compensatory damages excludable. Punitive damages taxable, except under § 104(c) where pre-1996 state law provided only punitive damages. |
IRC § 104(a)(2), (c) |
| Wrongful incarceration |
Excludable |
Excludable without dollar limit where the § 139F elements are met, including settlements; derivative family claims excluded from the exclusion. |
IRC § 139F; IRS FS-2023-26 |
| Wrongful termination / discharge |
Taxable |
Lost wages and severance taxable as wages; emotional distress taxable absent physical injury. Fee deduction generally available under the employment-claim catchall. |
Rev. Rul. 96-65; IRC § 62(a)(20), (e)(18) |
The Section 62(e) Catalogue: Employment, Civil Rights, and Retaliation Claims
Qualification under § 62(e) often decides whether a taxable employment recovery is taxed on the net or on the gross. Under Commissioner v. Banks the claimant’s income includes the contingent fee, and with miscellaneous itemized deductions suspended, the above-the-line deduction of § 62(a)(20) is the only route to deducting the fee for most individual claimants. The deduction covers attorney fees and court costs in any action involving a claim of unlawful discrimination as defined in § 62(e), a False Claims Act claim, or a Medicare Secondary Payer claim, and it is capped at the amount included in gross income from the judgment or settlement. IRC § 62(a)(20); Commissioner v. Banks, 543 U.S. 426 (2005); IRC § 67(g).
The claim requirement. Section 62(a)(20) allows the deduction only for attorney fees and court costs paid “in connection with any action involving a claim of unlawful discrimination” as defined in § 62(e). The claim is the gateway. In the absence of a claim of unlawful discrimination actually asserted in the action, and the associated enforcement of that claim, there is no basis for the above-the-line deduction; the fees fall back into the suspended miscellaneous itemized category, and the claimant is taxed on the gross recovery. IRC § 62(a)(20); IRC § 67(g).
The statutory term is narrower-sounding than its content. The eighteen paragraphs of § 62(e) reach far beyond status-based discrimination, and the two final paragraphs, highlighted below, carry most of the practical weight.
The eighteen paragraphs of IRC § 62(e)| Provision | Claims Covered | Practical Notes |
|---|
| § 62(e)(1) | Section 302 of the Civil Rights Act of 1991 (2 U.S.C. 1202): rights and protections extended to certain federal legislative-branch employment. | Narrow federal-employment provision. |
|---|
| § 62(e)(2) | Sections 201 through 207 of the Congressional Accountability Act of 1995: discrimination, leave, polygraph, WARN, and USERRA rights applied to congressional employees. | Covers the legislative-branch workforce. |
|---|
| § 62(e)(3) | The National Labor Relations Act: unfair labor practice claims, including retaliation for protected concerted activity. | Reaches well beyond status-based discrimination. |
|---|
| § 62(e)(4) | The Fair Labor Standards Act of 1938: minimum wage, overtime, and FLSA anti-retaliation claims. | Wage and hour recoveries qualify even though no one would call them discrimination in ordinary speech. |
|---|
| § 62(e)(5) | Sections 4 and 15 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. 623, 633a): private-sector and federal-sector age discrimination. | The Schleier claim type; recovery taxable, fees deductible above the line. |
|---|
| § 62(e)(6) | Sections 501 and 504 of the Rehabilitation Act of 1973: disability discrimination by federal employers and federally funded programs. | Companion to the ADA paragraphs below. |
|---|
| § 62(e)(7) | Section 510 of ERISA (29 U.S.C. 1140): interference with protected benefit rights and retaliation for exercising them. | Benefit-interference and retaliation claims, not benefit-denial claims as such. |
|---|
| § 62(e)(8) | Title IX of the Education Amendments of 1972: sex discrimination in federally funded education programs. | Applies outside the employment relationship. |
|---|
| § 62(e)(9) | The Employee Polygraph Protection Act of 1988. | Specialized statutory claim. |
|---|
| § 62(e)(10) | The Worker Adjustment and Retraining Notification Act: claims for failure to give required plant-closing and mass-layoff notice. | WARN back pay qualifies. |
|---|
| § 62(e)(11) | Section 105 of the Family and Medical Leave Act of 1993 (29 U.S.C. 2615): interference with FMLA rights and retaliation. | Leave-based claims qualify. |
|---|
| § 62(e)(12) | Chapter 43 of title 38, United States Code (USERRA): employment and reemployment rights of uniformed service members. | Military-service employment claims. |
|---|
| § 62(e)(13) | Sections 1977, 1979, and 1980 of the Revised Statutes (42 U.S.C. 1981, 1983, 1985): contract-equality, constitutional deprivation, and conspiracy claims. | Sweeps in § 1983 civil rights litigation, including claims against governmental defendants. |
|---|
| § 62(e)(14) | Sections 703, 704, and 717 of the Civil Rights Act of 1964 (Title VII): discrimination, retaliation, and federal-sector claims. | The core status-discrimination paragraph; § 704 separately captures retaliation. |
|---|
| § 62(e)(15) | Sections 804, 805, 806, 808, and 818 of the Fair Housing Act: housing discrimination and interference claims. | Applies outside the employment relationship. |
|---|
| § 62(e)(16) | Sections 102, 202, 302, and 503 of the Americans with Disabilities Act of 1990: employment, public services, public accommodations, and ADA retaliation. | ADA retaliation under § 503 is expressly listed. |
|---|
| § 62(e)(17) | Federal whistleblower protection provisions: any provision of federal law prohibiting the discharge of an employee, discrimination against an employee, or any other form of retaliation or reprisal for asserting rights or taking actions permitted under federal law. | The federal whistleblower-retaliation paragraph. It covers retaliation claims under federal whistleblower protection statutes generally; it is distinct from the award-program deduction under § 62(a)(21) discussed below. |
|---|
| § 62(e)(18) | The catchall: any provision of federal, state, or local law, or common law claims permitted under federal, state, or local law, (i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting discharge, discrimination, retaliation, or reprisal for asserting rights permitted by law. | The broadest paragraph. Employment contract claims, state and local civil rights claims, common law wrongful discharge, state wage claims, and state retaliation claims qualify here, because the paragraph reaches any aspect of the employment relationship. |
|---|
Whistleblower retaliation versus whistleblower awards. Section 62(e)(17) and § 62(a)(21) answer different questions. A whistleblower who suffers discharge, discrimination, or reprisal and recovers for the retaliation deducts fees above the line through § 62(a)(20) because the claim is unlawful discrimination under § 62(e)(17). A whistleblower who collects an award for information, under IRC § 7623(b), the SEC and CFTC programs, or a state false claims act, deducts fees above the line through § 62(a)(21). Both routes cap the deduction at the income included from the claim or award; neither permits a deduction below zero.
Caution
Reclassifying Claims as Civil Rights Violations to Capture the Deduction
A pattern has emerged in practice: a limited number of tax practitioners recommend that any claim, regardless of type, can be reclassified as a violation of the plaintiff’s civil rights, and that the recovery then supports the above-the-line deduction. Section 62(a)(20) does not support that position. The statute allows the deduction only for attorney fees and court costs paid in connection with an action involving a claim of unlawful discrimination as defined in § 62(e). Treatment of a recovery as unlawful discrimination in order to enjoy the benefit of the above-the-line deduction is improper unless each of the following is true.
First, the claimant must in fact have been a victim of unlawful discrimination as the statute defines it. The underlying facts must support the claim; the label does not.
Second, the claim must have been pled with specificity in the operative pleadings, identifying the claim and its underlying nature before settlement.
Third, the defendant must have expressly agreed in the settlement agreement to settle the enumerated claims of unlawful discrimination.
Recharacterizing settlement payments as resolving a civil rights claim contrary to the underlying facts or the pleadings, or in the complete absence of those declarations in the settlement agreement, does not create a claim of unlawful discrimination; it creates an improper deduction. On examination, the IRS will revert to the claims as pled and deny the deduction, and the position can expose the claimant, and potentially the advisor who recommended it, to penalties. Characterization is built in the complaint; it is not retrofitted in the release.
Business-Entity Claimants
Section 104(a)(2) protects persons, not enterprises. Courts and the IRS hold that a business entity cannot suffer a personal physical injury, so the exclusion is unavailable to corporate, partnership, and similar claimants. The point reaches closely held businesses, professional corporations, and medical practices, recoveries that personal-injury counsel may at first treat like an individual’s. Entity recoveries are analyzed entirely under the origin of the claim doctrine: a recovery replacing lost profits is ordinary income, and a recovery for injury to capital is a return of basis with any excess taxed as gain.
Common business-entity recoveries| Claim Type | Treatment | Summary and Caveats | Principal Authority |
|---|
| Antitrust (Clayton Act treble damages) | Taxable | The punitive two-thirds is gross income; the compensatory third is taxed by its origin, typically ordinary income as replaced profits. | Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) |
|---|
| Business defamation / disparagement | Taxable | Entities cannot use § 104(a)(2); recoveries for injured goodwill may be capital in character to the extent of basis in the injured asset. | IRC § 61; Raytheon Prod. Corp., 144 F.2d 110 (1st Cir. 1944) |
|---|
| Breach of contract / business interference | Taxable | Lost profits and lost business income are ordinary income. | Raytheon Prod. Corp., 144 F.2d 110 (1st Cir. 1944) |
|---|
| Intellectual property infringement | Mixed | Recoveries replacing royalties or lost sales are ordinary; recoveries for the taking or destruction of the IP asset itself can produce capital gain to the extent the asset qualifies. | IRC § 61 (origin of the claim) |
|---|
| Lanham Act (false advertising, trademark) | Taxable | Recoveries generally replace profits or compensate competitive injury; ordinary income in most postures. | IRC § 61 (origin of the claim) |
|---|
| Property and casualty recoveries | Mixed | Return of basis first; gain above basis, with possible § 1033 deferral on qualifying reinvestment. | IRC § 1033; Raytheon Prod. Corp. |
|---|
A specialized recapture provision, IRC § 186, can permit a deduction-offset for certain compensatory antitrust, patent infringement, and breach of contract recoveries where the underlying losses produced no tax benefit. The provision is narrow and rarely invoked; entities with large historical losses should raise it with tax counsel.
Planning Observations and Recurring Traps
The gross income trap on attorney’s fees. Under Commissioner v. Banks, a claimant’s income includes the contingent fee paid to counsel. For claims within the § 62(e) catalogue in Part Four, and for False Claims Act and listed whistleblower awards, § 62(a)(20) and (21) restore parity through an above-the-line deduction capped at the income included from the claim. For taxable claims outside those categories (defamation is the recurring example), the suspension of miscellaneous itemized deductions leaves many claimants taxed on the gross recovery. Fee structuring and claim characterization deserve attention before signing, not after.
Court-awarded and statutory fees. Fees a defendant pays under a fee-shifting statute, and fees a court awards separately from the damages, are still generally income to the claimant under Banks before any deduction, and they can carry their own character separate from a contingency fee measured against the recovery. Whether the above-the-line deduction reaches them turns on the same category test: the deduction is available where the fees arise from a claim of unlawful discrimination, an employment claim, a False Claims Act claim, or a listed whistleblower award, and is capped at the income included from the claim. The interaction of a statutory fee award with a contingency agreement affects the plaintiff’s net and the lawyer’s fee planning and should be modeled before settlement. Commissioner v. Banks, 543 U.S. 426 (2005); IRC § 62(a)(20), (21).
Allocate in the agreement, with support in the record. Express allocations among claims are generally respected when consistent with the substance of the dispute. An allocation that contradicts the complaint, the discovery record, or the negotiating history invites recharacterization on examination.
Interest erodes exclusion. Statutory pre-judgment interest is taxable even on a fully excludable physical injury award, and it can represent a large share of an old claim. Settling before judgment, or structuring the resolution, can affect how much of the recovery carries interest character.
Periodic payment design. For excludable claims, § 104(a)(2) shelters the entire periodic payment stream, including embedded growth, when the structure satisfies § 130. For taxable claims, non-qualified structures and qualified settlement funds under § 468B manage timing. These tools have formal requirements; defective design forfeits the benefit.
Risks and counterarguments. The general rules above have well-developed exceptions, and two cautions apply to any chart of this kind. First, the physical versus non-physical line under § 104(a)(2) is the most litigated boundary in this field, and outcomes turn on medical evidence, pleading, and allocation rather than on claim labels. Second, the IRS is not bound by the parties’ characterization; a settlement agreement is the beginning of the analysis, not the end. Readers should treat every entry above as a starting presumption subject to displacement by the facts of the particular matter.
Required Reading
Disclosure and Acknowledgment
Educational purpose; no advice. Eastern Point Trust Company (“EPTC”) publishes this material for educational purposes only. Nothing in it constitutes legal, tax, accounting, or investment advice, and nothing in it creates an attorney-client, advisor-client, or fiduciary relationship between EPTC and any reader. The application of federal tax law to any settlement depends on facts specific to that matter, including the pleadings, the settlement agreement, the allocation of proceeds, and the claimant’s individual tax circumstances, none of which general educational material can take into account.
Consider taxation before the claims are filed. The IRS Lawsuits, Awards, and Settlements Audit Techniques Guide directs examiners to begin with the claims as pled: the complaint and the litigation record are the primary evidence of the origin and character of the claims a settlement resolves. A settlement agreement that attempts to recharacterize the claims as pled invites the examiner to disregard the settlement terms and revert to the pleadings. Taxation therefore needs to be considered before the claims are filed, not for the first time at the settlement table. Claims should be pled with specificity sufficient to identify each claim and its underlying nature. The settlement agreement should then restate those claims, recite the defendant’s intent to settle each enumerated claim, and identify the intended tax character, taxable or non-taxable to the plaintiff, of each payment; such recitals do not bind the IRS, but they carry weight when consistent with the pleadings and the record. Specificity is the claimant’s friend. A semantic duel with the IRS is a contest the claimant rarely wins.
Independent verification required. The taxation of litigation settlements is fact-specific and changes as statutes, regulations, rulings, and case law develop. Before acting on, relying on, or making any decision based on the general principles described here, readers should retain experienced tax counsel or a certified public accountant to verify the tax treatment of their specific settlement or judgment.
State and local taxes. This material addresses federal income tax treatment only. Most states base the taxation of settlement proceeds on federal treatment, but some states, municipalities, and localities treat portions of settlement payments differently for tax purposes. State and local treatment falls outside the scope of this material and must be verified through the reader’s own tax advisor or tax counsel.
Completeness. EPTC believes this material to be materially complete, but EPTC does not guarantee that every category of claim has been included. The omission of a claim type is not dispositive of whether proceeds from that claim are taxable or non-taxable; an omission means only that the claim type is not addressed here, and its treatment must be evaluated on its own facts with qualified advisors.
No guarantee of accuracy or coverage. This material is intended to be exhaustive, but EPTC does not guarantee that the information it contains is fully accurate as applied to any specific case, nor that it identifies the tax treatment applicable to every variation of settlement. Settlement structures, allocations, and underlying claims vary widely; the general treatment described here may not hold for a particular variation.
Disclaimer of liability; reader acknowledgment. EPTC expressly disclaims all liability for any losses, damages, or adverse financial outcomes resulting from reliance on this information without independent verification by experienced tax counsel or a certified public accountant. By using this content, the reader acknowledges the limitations described in this disclosure, agrees that EPTC has no responsibility for decisions made in reliance on general educational material, and assumes full responsibility for verifying the information before acting on it.
Currency of content. This material reflects authorities available as of June 11, 2026. EPTC undertakes no obligation to update it as the law changes.
