Personal injury settlement taxes
Taxes on a personal injury settlement: what section 104 excludes and what the IRS taxes.
For personal injury plaintiffs and the lawyers who represent them: compensatory damages for a physical injury or physical sickness, including lost wages, are generally excluded from income, and punitive damages and interest are generally taxable. The IRS generally respects the agreement's allocation when it matches the substance of the claims that were settled.
Mr. Powell of the Law Office of Alexander Powell, PLLC handles the federal tax side of a settlement for personal injury plaintiffs and their lawyers: the federal tax treatment of the allocation, a Form 1099 the payer plans to issue, and an unpaid IRS balance or federal tax lien that can reach the proceeds, while the client's personal injury lawyer keeps the case. He is admitted in the District of Columbia and Maryland, works from 1629 K Street NW, Suite 300 in Washington, DC, and handles IRS matters nationwide.
26 U.S.C. sections 104 and 6321, Treasury Regulation 1.104-1, IRS Publications 4345 and 525, and the IRS page on the tax implications of settlements and judgments were checked on govinfo.gov, law.cornell.edu, ecfr.gov, and irs.gov on November 8, 2026. Whether a settlement is taxable depends on all the facts. This page is not legal advice.
The rule
Compensatory damages for a physical injury are generally excluded; punitive damages and interest are generally taxable.
Under 26 U.S.C. section 104(a), except for amounts attributable to, and not in excess of, medical expense deductions allowed for a prior taxable year, paragraph (2) excludes from gross income the amount of any damages, other than punitive damages, received by suit or agreement, as lump sums or as periodic payments, on account of personal physical injuries or physical sickness. IRS Publication 4345 says that when the recipient did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount of a settlement for personal physical injuries or physical sickness is non-taxable; it separately says punitive damages are taxable even in that kind of settlement, and that interest on any settlement is generally taxable. The IRS page on the tax implications of settlements and judgments says compensatory damages, including lost wages, received on account of a personal physical injury are excludable from gross income, with the exception of punitive damages.
Is money for emotional distress in a settlement taxable?
It depends on where the distress comes from. For section 104(a)(2), emotional distress is not treated as a physical injury or physical sickness, except for damages not in excess of the amount paid for medical care attributable to emotional distress. IRS Publication 4345 says proceeds for emotional distress attributable to a personal physical injury or physical sickness are treated the same as proceeds for the physical injury, and proceeds for emotional distress that does not originate from one are included in income, reduced by related medical expenses not previously deducted and by previously deducted ones that provided no tax benefit. Publication 525 says emotional distress itself is not a physical injury or physical sickness and includes physical symptoms that result from it, such as headaches, insomnia, and stomach disorders.
Are punitive damages in a personal injury settlement taxable?
Yes, with one narrow exception. Section 104(a)(2) excludes damages other than punitive damages, and IRS Publication 4345 says punitive damages are taxable even if they were received in a settlement for personal physical injuries or physical sickness. Section 104(c) makes a narrow exception for punitive damages awarded in a wrongful death action where the applicable state law, as in effect on September 13, 1995, provides, or had been construed by a court decision issued on or before that date to provide, that only punitive damages may be awarded in such an action. The exception does not apply to actions filed on or after the date the state law stops providing, or is no longer construed to provide, that treatment.
Is interest on a settlement or judgment taxable?
Generally yes. IRS Publication 4345 says interest on any settlement is generally taxable as interest income, and IRS Publication 525 lists interest on any award as ordinary income. Section 104(a)(2) excludes the damages themselves, other than punitive damages, received on account of personal physical injuries or physical sickness, whether as lump sums or as periodic payments.
Official source: 26 U.S.C. 104
Official source: IRS Publication 4345, Settlements: Taxability
Official source: IRS Publication 525, Taxable and Nontaxable Income
Official source: IRS, Tax implications of settlements and judgments
When the client already owes the IRS.
Under 26 U.S.C. section 6321, if a person liable to pay a tax neglects or refuses to pay it after demand, the amount, with interest and penalties, becomes a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to that person. Section 6321 contains no exception for settlement proceeds that section 104 excludes from income. For a client with an assessed balance left unpaid after the IRS's demand, the lien can reach the client's right to the proceeds.
The options for an assessed balance, including a payment plan, an offer in compromise, and the release or discharge of a lien, are on IRS collections and federal tax lien.
When I take on a settlement tax question.
I take on a settlement tax question when the tax answer affects the agreement or the proceeds: a draft agreement that allocates the recovery among the claims being settled; a client who deducted medical expenses in an earlier year; a client whose payer plans to issue a Form 1099 for part of the recovery; or a client with an IRS balance, a federal tax lien, or unfiled returns.
For personal injury lawyers: the personal injury case stays with you, and the firm quotes fees in writing before any work begins. You can send a high-level summary through the referral option on the intake form: the kinds of claims, whether a draft allocation exists, and any IRS notice the client holds, with the date printed on it.
Questions
Common questions.
Are medical expenses in a settlement taxable?
In a physical injury settlement, only to the extent they were deducted before and the deduction gave a tax benefit. Section 104(a) excludes the damages except for amounts attributable to, and not in excess of, medical expense deductions allowed under section 213 for a prior taxable year. IRS Publication 4345 says a recipient includes in income the portion of a physical injury settlement that is for medical expenses deducted in a prior year, to the extent the deduction provided a tax benefit.
Does the way a settlement agreement allocates the money matter?
Yes. IRS Publication 4345 says a settlement payment may consist of multiple elements allocated by the parties, such as back pay, emotional distress, and attorneys' fees, and that the IRS generally will not disturb an allocation if it is consistent with the substance of the settled claims. Publication 525 says that to determine whether settlement amounts are included in income, you consider the item that the settlement replaces.
Are the attorney fees in a settlement taxable to the client?
It turns on whether the underlying recovery is taxable; in a physical injury settlement, punitive damages and interest generally are. IRS Publication 525 lists attorney fees and costs, including contingent fees, as ordinary income where the underlying recovery is included in gross income. The IRS page on the tax implications of settlements and judgments says that when the settlement payment is includable in the plaintiff's income, the payer must report the attorney's fees on separate information returns with the attorney and the plaintiff as payees.
Official source: IRS Publication 4345, Settlements: Taxability
Official source: IRS Publication 525, Taxable and Nontaxable Income
Official source: IRS, Tax implications of settlements and judgments
Related pages
Related pages.
- Federal tax lienRelease, withdrawal, discharge, and subordination.
- IRS levyBank, wage, and other levies, and how they are released.
- IRS collectionsLiens, levies, and payment options for an assessed balance.
- Unfiled tax returnsFederal, D.C., and Maryland years that were never filed.
- IRS tax debt in bankruptcyThe discharge tests for IRS tax debt.
- Practice areasFederal, District of Columbia, and Maryland tax controversy matters.
Send a short summary of the settlement.
Say what kinds of claims are being settled or were settled, whether there is a draft allocation, and whether there is an IRS balance or unfiled returns. Send only a high-level summary.
Requesting a consultation does not make Mr. Powell your lawyer, provide legal advice, or protect a deadline.
Law Office of Alexander Powell, PLLC. 1629 K Street NW, Suite 300, Washington, DC 20006.