The winnings would be taxable income if they are "punitive". If they
are "compensatory," they are non-taxable. Internal Revenue Code (IRC)
section 61 states that all income from whatever source is taxable.
However, compensatory settlements would be to compensate for a prior
loss on the part of a plaintiff, and so would not represent a gain of
income on their part and they would not have to be taxed.
An IRS study found that many lawsuit winnings were falling through the
cracks as reportable income, or that people were classifying
non-compensatory settlements as compensatory, so there are many ways
to get around this.
IRS Code 104(a)(2) states that lawsuits involving personal injury or
illness are excluded from taxation, but the IRS has found many cases
of fraud related to this and there are many court cases stemming from
it. Issues litigated have included whether mental anguish counts as a
personal sickness or injury, or whether personal injury damages are
actually punitive. "The Service's current position is that punitive
damages are not received on account of personal
injuries under IRC section 104(a)(2), and therefore are not excludable
from gross income."
Other than that, there are no specific statutes on which types of
lawsuits are exempt or not. Most cases have elements of both kinds of
compensation. The courts at the time of settlement deem whether the
money is compensatory or punitive, and the plaintiff must abide by
Usually, the settlement will designate which part of the settlement is
compensatory and which is punitive, making it easy on the IRS and the
However, it is possible to take legal fees as an itemized deduction:
"Whenever a plaintiff wins money in a lawsuit, certain I.R.S.
provisions cover whether or not that money is taxable. From the Los
'In many instances, a plaintiff can take the legal fees as an
itemized deduction on his tax form. However, those itemized deductions
gradually fade for high-income earners. In addition, as the court
noted, taxpayers subject to the alternative minimum tax ? the special
levy created to make sure wealthy filers could not evade taxation by
claiming lots of deductions and credits ? are not allowed any
miscellaneous itemized deductions.'"
In fact, a Supreme Court decision has decided that not only are the
plaintiff's actual proceeds taxable as income, but so is the original
reward, before the attorney's fees are subtracted. An explanation can
be seen here:
If you have any more questions or need any more help, let me know and
I'll be glad to help you out.