Are class action settlements taxable? Everything you need to know

Receiving money from a class action settlement can feel like closing a tough chapter. A company wronged you, justice was served, and now you’re finally being compensated. But when that check arrives, it suddenly dawns on you that you might not get to keep the full amount, as the Internal Revenue Service (IRS) may want a portion of it.

So, are class action settlements taxable, and under what circumstances? In this article, we’ll explain which types of class action payouts are subject to tax and explore common tax-related challenges to help you avoid surprises and penalties when filing your return.

Which class action settlements are taxable?

When deciding whether a class action settlement counts as taxable income, the IRS considers the nature of the case. In other words, it focuses on why you received the money.

To show you how these rules work in practice, we’ll look at how taxes apply to different types of class action claims, including: 

1. Personal injury
2. Emotional distress
3. Employment
4. Insurance
5. Defamation, libel, or slander
6. Legal, tax, or financial malpractice
7. Punitive damages

Personal injury cases

Under Section 104 of the Internal Revenue Code (IRC), the money you receive because of a personal injury or physical sickness isn’t considered taxable income, and you don’t have to pay tax on it. This exemption covers:

• Compensation for physical injuries or illness, whether you received it as a lump sum or in smaller periodic payments
• Payments you receive under workers’ compensation laws for personal injuries or sickness
• Payouts from accident or health insurance policies that cover injury or illness

There’s one key exception, though: if part of your settlement payout reimburses you for medical expenses you already deducted on your taxes and received a benefit for, that portion becomes taxable.

Emotional distress or mental anguish cases

Class action settlements for emotional distress or mental anguish are usually considered taxable income. The only time they’re tax-free is when the distress results directly from a physical injury or illness.

Employment cases

Settlements from employment-related class actions, like those involving lost wages, involuntary termination, or workplace discrimination, are typically fully taxable. 

You’ll need to pay income tax on the amount you receive, and if a portion of the payout covers your lost wages (such as severance pay, front pay, or back pay), payroll taxes will also apply to that portion.

Insurance cases

Insurance settlements can be a bit tricky: whether you’ll pay tax on them depends on the type of compensation. Here’s a quick overview to help you make sense of it:

Defamation, libel, or slander cases

Settlements from defamation cases, including libel or slander, are fully taxable as income. These payouts usually cover damages like:

• Emotional distress
• Reputational harm
• Punitive damages

Legal, tax, or financial malpractice cases

Settlements from legal, tax, or financial malpractice class actions are fully taxable as income. These cases often involve issues like:

• Bad legal advice that leads to financial loss
• Incorrect tax filings
• Failure to share important information
• Breach of professional duty

Cases involving punitive damages

Punitive damages, sometimes known as exemplary damages, are extra payments a court may order on top of compensatory damages to punish a defendant for especially wrongful or reckless behavior. They’re also meant to send a message and discourage similar actions in the future.

For example, in the famous Exxon Shipping Co. v. Baker class action case, the defendant had to pay $500 million in punitive damages in addition to compensatory awards. 

Unlike compensation for actual losses or injuries, punitive damages are always fully taxable, no matter what the case is about. So even if your class action settlement involves personal injury or illness (which is generally tax-free), you’ll still need to pay tax on the punitive portion of the payout.

Common tax challenges in class action settlements

When it comes to class action settlements, two of the biggest tax challenges people face are:

1. Mixed settlements
2. Legal fees

Mixed settlements

Many class action settlements combine both taxable and non-taxable components. If you don’t separate these properly, you could either end up paying more tax than you owe or face penalties for not paying enough.

In many cases, the settlement agreement itself will spell out which parts are taxable and which aren’t, so you can rely on it when the time comes to file your taxes. 

If those details aren’t included in the agreement, the IRS will look at the payer’s intent to determine how each portion of the settlement should be taxed. In that case, you might need to provide documentation or other proof to show how different parts of your settlement should be treated.

Legal fees

You can’t start a class action lawsuit without a lawyer. Thankfully, most class action attorneys work on a contingency fee basis, which means they get paid only if they win the case. Typically, the law firm fronts all the costs associated with a class action and then takes a certain percentage of the settlement. Once legal fees are deducted, whatever’s left is distributed among the class members.

The problem: although these legal fees are taken out before you get your share of the settlement, you may still owe taxes on the full payout amount, not just on what you actually received. For example, if your share of the total settlement is $1,000 after fees, but the gross amount before deductions was $1,500, the IRS could tax you as if you received the full $1,500.

There are a few exceptions, though. You’ll typically pay tax only on the net amount (after legal fees) if:

1. The lawsuit was an opt-out class action (meaning you were automatically included in the class unless you chose to opt out).
2. You didn’t sign a separate contingency or retainer agreement with the lawyers (you were just part of the standard class action arrangement).

In some cases, you can also deduct legal fees “above the line” on your tax return. That means the deduction comes off your gross income before calculating your adjusted gross income, effectively lowering how much tax you actually owe. For example, many employment-related cases qualify for this kind of deduction, though it ultimately depends on the type of claim involved.

How can Settlemate simplify your way to class action payouts?

Figuring out whether your class action settlement is taxable is a problem you’ll tackle only after you’ve actually received the payout. But to get there, you’ll first need to file a claim; class membership may be automatic, but the claims process isn’t.

The thing is, many people don’t even realize they qualify for a payout as class members in an ongoing class action lawsuit. And those who do often give up when confronted with the tedious claims process. The result is the same: you miss out on money that’s rightfully yours.

That’s where Settlemate comes in. It takes the hassle out of the process by automatically finding settlements you’re eligible for and helping you claim your share quickly and easily. Here are some of the features that make this possible:

• Automated scanning: With your permission, Settlemate scans your purchase history and emails to match you with all class action settlements you’re eligible for.
• Pre-filled claim forms: Whenever possible, Settlemate will automatically fill out the claim forms so you can submit them directly through the app, without lawyers or legwork.
• Real-time tracking and notifications: Settlemate keeps you updated on the progress of your claims, payout estimates, and deadlines. You’ll also get an alert every time a new eligible settlement appears.
• Proof guidance: If a particular claim requires proof, Settlemate will let you know and clarify what documents you’ll need to submit.

Download the Settlemate app from the App Store or Google Play, set up your account, and start claiming the money you’re owed—it’s that simple.

Settlemate also gives you peace of mind with its generous refund policy. If the money you recover through the app doesn’t cover your subscription cost within the first year, you may be eligible for a full refund.

Frequently asked questions

We’ve addressed frequently asked questions regarding the taxation of class action settlements:

How much taxes do you pay on a settlement?

There’s no flat tax rate you pay on class action settlements. How much you’ll owe depends on your tax bracket, i.e., your total taxable income for the year, since taxable settlements are typically treated like ordinary income.

How do you report and file settlement income?

Most taxable settlement payments are reported on either Form 1099-MISC or Form W-2 of your tax return, depending on the type of settlement. Keep your settlement agreement and other relevant documentation on hand in case the IRS asks for clarification or conducts an audit.

How can you lower taxes on class action settlements?

You may be able to reduce your tax burden by choosing structured payments instead of a single lump-sum payout. This spreads your income over several years, which can sometimes keep you in a lower tax bracket. However, not all settlement arrangements offer this option, so you should talk with your lawyer to see if you could benefit from structured payments.

‍