Are Legal Settlements Tax-Deductible? Understanding Your Options

3 November 2025

Legal settlements can be life-changing, often marking the end of stressful disputes or unexpected challenges. Whether you're dealing with a personal injury payout, a workplace discrimination case, or even a contract dispute, getting that settlement check can feel like a victory. But hold on—before you mentally allocate those funds to a tropical vacation or paying off bills, there's one crucial question you might overlook: Are legal settlements tax-deductible?

Taxes are like that pesky fly at a summer picnic—they always seem to show up when you're just about to relax. But don’t worry, by the end of this article, you’ll know exactly how legal settlements and taxes intertwine, and what you can (and can’t) deduct when it’s time to file.

Settlements and Uncle Sam: Let’s Talk Basics

Before diving into the nitty-gritty, let’s talk about what legal settlements actually are. Settlements are financial agreements that resolve a dispute without going to a full trial. Both individuals and businesses can receive—or pay—settlements.

Now, the million-dollar question (or maybe just a thousand-dollar one): Are legal settlements taxable? And if you're paying one out, can you deduct it?

The answer? It depends. Frustratingly vague, right? But hang tight, we’ll break it all down.

The IRS Rulebook: When Are Settlements Taxable?

First, let’s see where the IRS stands. Whether the legal settlement you receive is taxable hinges on what the payment is compensating you for.

Settlements That Are Taxable

Here’s the bad news: many legal settlements are considered taxable income. Some of these include:

1. Lost Wages or Income
If you win a settlement because you weren’t paid properly (e.g., wrongful termination or wage theft), this counts as taxable income. Why? Because it’s essentially replacing what you would’ve earned—just like a paycheck, and we all know paychecks don’t dodge taxes.

2. Punitive Damages
Punitive damages, designed to punish the other party rather than compensate you, are almost always subject to tax.

3. Interest on Settlements
If your settlement includes interest for the time you were “waiting” for the money, that part is also taxable. Think of it as earning interest on a savings account—hardly free money, right?

4. Breach of Contract Awards
Settlements related to a breach of contract are usually taxable unless they involve physical injury or illness (more on that in a sec).

Settlements That Are NOT Taxable

Good news, though—not every penny Uncle Sam gets his hands on. Here are some settlements that may not be taxable under the right circumstances:

1. Personal Injury or Illness Settlements
If a settlement compensates you for physical injuries or sickness, that money is typically not taxable. For example: slip-and-fall cases, car accidents causing injuries, or medical malpractice settlements.

However, punitive damages from these cases—the extra "punishment" payment? Those can be taxable even if your injury settlement isn’t.

2. Reimbursements for Medical Bills
Payments that specifically reimburse you for medical expenses related to injury are generally not taxed. This rule applies only if you didn’t previously deduct those same medical costs on your tax return.

3. Emotional Distress Tied to Physical Injuries
If your emotional distress stems from a physical injury, it’s likely not taxable. But emotional distress that isn’t tied to an injury? Taxable. Confusing, right? The IRS basically says, “Show me a doctor’s note.”

Deducting Legal Settlements: What About Payers?

We’ve talked about recipients, but what if you’re on the paying end of a settlement? Can you breathe a sigh of relief knowing you might deduct those payments? Let’s see.

Are Legal Settlements Tax-Deductible for Businesses?

If you're a business paying a legal settlement, some payments are deductible. Businesses can generally deduct:

1. Costs Related to Business Operations
If the settlement resolves an issue directly tied to your business—like disputes with customers, vendors, or employees—you can likely write it off. For example, a business paying a settlement in a workplace discrimination lawsuit may qualify for a deduction.

2. Legal Fees
The legal fees associated with defending your business or reaching a settlement are often deductible as a business expense. However, keep in mind that personal legal fees don’t enjoy the same perk—more on that below.

Settlements You Can’t Deduct

It’s not all sunshine and tax breaks, though. Certain payments are off-limits when it comes to deductions. Here are the ones you’ll need to cough up without any tax relief:

1. Fines and Penalties
Any fines or penalties paid to a government agency (e.g., EPA fines, SEC penalties) are not deductible. Why? Congress doesn't want to subsidize bad behavior. It’s like giving someone a high-five for messing up.

2. Personal Legal Fees
If you're an individual, legal fees for personal matters—such as divorce or estate planning—are almost never deductible. The IRS says those costs are personal and not business-related.

3. Certain Sexual Harassment Settlements
Under the 2017 Tax Cuts and Jobs Act, settlements related to sexual harassment or abuse are not deductible if they include a nondisclosure agreement. This rule aims to discourage using hush money to sweep issues under the rug.

So… What Are Your Options?

By now, your brain might be swimming in tax rules and IRS jargon, so let’s simplify things. Need help? Here are some actionable steps to take if you’re dealing with a legal settlement.

1. Get Tax Advice Early
Before signing any settlement agreement, consult with a tax advisor. They can help you structure the settlement to minimize your tax burden. For example, allocating payments to non-taxable categories (e.g., physical injury compensation) where possible.

2. Leverage Deductions
If you’re a business, work with an accountant to make sure you’re claiming every deductible expense related to the settlement. From legal fees to direct payments, there may be valuable deductions lurking in the fine print.

3. Understand State Tax Rules
State tax laws can differ from federal ones, so don’t assume the IRS’s rules apply everywhere. Double-check how your state handles legal settlements.

4. Keep Good Records
Whether you’re receiving or paying a settlement, document everything. Proper paperwork can be your best friend if the IRS comes knocking.

Key Takeaways

Legal settlements and taxes might not be the most exciting topic, but understanding them can save you a lot of money (and stress) in the long run. Whether you’re receiving a settlement check or cutting one, knowing what’s taxable and what you can deduct is essential.

Remember, when in doubt, call in the experts. A small investment in a tax professional can pay off big when it comes to navigating the murky world of taxes and legal settlements. After all, no one wants to get tangled up in a mess with the IRS—they’re scarier than a parent with your bad report card.