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The settlement agreement says your client recovered $900,000. Six months later, the client calls asking why they owe tax on nearly the entire amount, including money paid directly to their lawyer. Nothing went wrong with the litigation. The settlement was paid and the case closed. The problem lies in the settlement agreement.
Litigation lawyers spend substantial time negotiating liability and damages. Far less attention is given to how a recovery will be taxed. Yet tax consequences can dramatically affect what a client keeps. In some cases, a poorly structured settlement can reduce a recovery’s economic benefit significantly. Many of these issues can be addressed before a settlement agreement is signed. After the funds are paid and reporting forms are issued, the opportunities become more limited.
Characterization matters
The starting point is Internal Revenue Code Section 61, which generally provides that all income is taxable unless a specific exclusion applies. When evaluating settlements and judgments, the IRS focuses on a simple question: What was the payment intended to replace? In other words, the IRS wants to know what the lawsuit was really about, not what the settlement agreement calls it.
If a payment replaces lost wages, it is generally taxed like wages. If it replaces lost business profits, it is generally taxed as ordinary income. If it compensates for property damage, the analysis may depend on the taxpayer’s basis in the property and whether the payment represents a return of capital, capital gain, or ordinary income. The most common exception, in Internal Revenue Code Section 104(a)(2), covers damages received on account of personal physical injuries or physical sickness. That exclusion is narrower than many lawyers assume. Emotional-distress damages, for example, remain taxable unless they are tied to a qualifying physical injury or sickness. A narrow exception applies to damages for medical care tied to that emotional distress.
For litigators, this distinction can mean the difference between a largely tax-free recovery and an unpleasant surprise the following April. The issue arises frequently in employment, harassment, discrimination, civil rights, and defamation cases, where emotional distress claims often make up a significant portion of the settlement value. Understanding the underlying claims is often more important tha n understanding tax law itself. The tax result usually follows the claim. Careful drafting still matters, as discussed below.
Settlement terms, tax terms
Although the underlying claims drive the analysis, settlement language still matters. A carefully drafted agreement can provide evidence of the parties’ intent and the nature of the payment. The IRS will more likely respect an allocation that reflects the claims asserted and the evidence developed during litigation than one that appears driven solely by tax considerations.
Consider an employment case that settles for $600,000. If the agreement simply states that the plaintiff receives $600,000 in exchange for releasing all claims, there is room for dispute over how much represents wages, emotional distress, or other categories of recovery. Had the agreement allocated specific amounts consistent with the litigation record, the parties would be in a stronger position.
Employment settlements deserve attention because they combine multiple categories of damages into a single payment. Some portions may be treated as wages; others may not. Some amounts may be subject to withholding obligations, while others may trigger information-reporting requirements. Liquidated damages and statutory penalties, common in wage-and-hour claims, illustrate the point: Although the liquidated-damages component is taxable, it is not treated as “wages” for withholding purposes and is typically reported on Form 1099 rather than Form W-2, while the accompanying back pay remains ordinary wages subject to withholding. Attorney fees can present another surprise.
Many plaintiffs assume they pay tax only on money they actually receive. However, under the Supreme Court’s decision in Commissioner v. Banks, 543 U.S. 426 (2005), plaintiffs must include in income the entire recovery, including amounts paid to their attorneys under a contingent-fee arrangement. Congress has provided a narrow above-the-line deduction for attorney fees in certain unlawful-discrimination and whistleblower claims under Section 62(a)(20). For recoveries outside those categories (defamation and other tort claims, for example), the fee is not deductible above the line, and because miscellaneous itemized deductions were permanently eliminated by the One Big Beautiful Bill Act (effective in 2026), the plaintiff can be taxed on the entire recovery with no offsetting fee deduction. That is the trap in the $900,000 settlement described at the outset of this article.
Punitive damages can create similar problems. Many litigants assume punitive damages share the claim’s tax treatment. That assumption is incorrect. Specifically, punitive damages are taxable even when they arise from a physical-injury claim that is otherwise excludable under Section 104(a)(2). In Indiana, that means the portion the plaintiff actually receives: Under Indiana Code Section 34-51-3-6, a plaintiff who wins punitive damages at trial keeps 25%, with the remaining 75% paid directly to the state’s Violent Crime Victims Compensation Fund and never reaching the plaintiff. The Indiana Supreme Court has held the plaintiff has no property interest in that remaining share, Cheatham v. Pohle, 789 N.E.2d 467 (Ind. 2003), and IRS guidance addressing similar state statutes has treated a state’s mandated share as excluded from the plaintiff’s gross income. That reasoning is strongest on an actual verdict, though, not a settlement merely labeled “punitive damages.” Likewise, prejudgment and post-judgment interest can generate taxable income even when the underlying recovery receives more favorable treatment. These issues are not merely tax questions. They are settlement questions.
For Indiana practitioners, this analysis does not stop at the federal return. Indiana adjusted gross income begins with federal adjusted gross income, subject to specified modifications, so the federal characterization carries through. Amounts excluded from federal income under Section 104(a)(2) drop out of the Indiana base, while amounts includible federally (including the contingent-fee portion required by the Banks decision, punitive damages and interest) are taxed at Indiana’s flat rate absent a specific modification.
Determining the tax fight
Most litigators do not need to become tax lawyers but should recognize when tax considerations may affect a settlement’s value. Before finalizing a significant settlement, counsel should work through a few questions. What claims is the payment intended to resolve, and does the agreement allocate damages among the categories of recovery? Is that allocation supported by the pleadings and record? Will any portion be treated as wages? Could attorney-fee issues affect the client’s after-tax recovery? Have the parties considered the reporting consequences before year-end forms are issued?
Spending some extra time analyzing these questions before finalizing a settlement agreement can save a client far more than months of post-settlement tax planning ever will. Settlement negotiations should not end when the parties agree on a number. In many cases, the words used to describe that number determine how much of it the client keeps.
For litigators, tax characterization is not merely a tax issue. It should be part of the settlement itself.•
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Schnurpel is of counsel at Krieg DeVault LLP and advises clients on federal, state and local tax matters.
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