For most personal injury settlements, attorney fees are not deductible, and that is generally good news rather than bad. A settlement for physical injuries is excluded from taxable income entirely under Internal Revenue Code section 104(a)(2), so there is nothing to deduct and nothing to tax. The deduction question only bites on the taxable pieces of a recovery, such as punitive damages and interest.
B&D Injury Law Group represents injured people across California. This article explains which parts of a settlement are taxed, why the fee deduction usually does not matter, and the situations where it matters a great deal.
Start With What Is Taxed
Internal Revenue Code section 104(a)(2) excludes from gross income the amount of any damages, other than punitive damages, received on account of personal physical injuries or physical sickness, whether by suit or agreement and whether as lump sums or periodic payments.
The word “physical” carries enormous weight and was added deliberately by the Small Business Job Protection Act of 1996. Emotional distress standing alone is not treated as a physical injury or physical sickness. If your distress flows from a physical injury, the damages for it are treated the same as the physical injury damages and are excluded. If there is no underlying physical injury, distress damages are taxable, except to the extent they do not exceed amounts paid for related medical care.
| Component of a recovery | Taxable? |
|---|---|
| Compensation for physical injury or physical sickness | No, excluded under § 104(a)(2) |
| Emotional distress flowing from a physical injury | No, treated the same as the physical injury |
| Emotional distress with no physical injury | Yes, beyond related medical care costs |
| Lost wages in a physical injury case | No, they are part of the excluded damages |
| Punitive damages | Yes, always |
| Interest on the settlement or judgment | Yes, as interest income |
| Medical expenses you deducted in a prior year | Yes, to the extent the deduction gave you a tax benefit |
Why the Fee Deduction Usually Does Not Matter
In a straightforward physical injury case, the entire recovery is excluded from income. You never include the gross amount, so the portion paid to your attorney never enters your income in the first place. There is nothing to deduct because there was nothing taxed.
There is also an independent rule barring the deduction. Section 265(a)(1) disallows any deduction allocable to income that is wholly exempt from tax. Even if you wanted to claim the fee, it would be disallowed as allocable to exempt income.
The practical result is neutral, and favorable. On a physical injury settlement, you are not taxed on the money that went to your lawyer.
Where It Does Matter: Taxable Recoveries
The picture reverses when a recovery is taxable, and the reversal is harsh.
In Commissioner v. Banks, 543 U.S. 426 (2005), the Supreme Court held that when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee. The reasoning is anticipatory assignment of income: you cannot avoid tax on money by directing it to someone else.
So on a taxable recovery, you are taxed on the gross, including the third or more that went to your lawyer. The obvious question is whether you can deduct that fee to offset it. For most claimants, the answer is now no, permanently.
The 2025 Change Most Articles Have Not Caught
The Tax Cuts and Jobs Act suspended miscellaneous itemized deductions, which is the category attorney fees on a taxable recovery would fall into. That suspension was originally scheduled to expire after 2025, and a great many articles still say so.
It did not expire. The One Big Beautiful Bill Act, Public Law 119-21, enacted July 4, 2025, made the suspension permanent and renumbered it. The operative provision is now section 67(h), which reads that notwithstanding subsection (a), no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017. The change applies to taxable years beginning after December 31, 2025.
Two practical consequences. First, if you are reading an article that cites section 67(g) for this rule, it is describing the pre-2026 numbering; section 67(g) now addresses educator expenses. Second, and more importantly, what used to be a temporary problem scheduled to sunset is now a permanent feature of the code. A claimant with a fully taxable recovery who does not fit an above-the-line exception is taxed on the gross, including the contingency fee, with no offsetting deduction at all.
The Above-the-Line Exceptions, and Why They Do Not Help
Congress created above-the-line deductions for attorney fees in two categories. Section 62(a)(20) covers claims of unlawful discrimination, and section 62(a)(21) covers whistleblower awards.
Section 62(e) defines unlawful discrimination by listing specific statutes: the Civil Rights Acts, the ADA, the ADEA, the FLSA, the NLRA, the FMLA, ERISA, the Rehabilitation Act, Title IX, the Fair Housing Act, and state and local laws regulating employment or civil rights, among others.
Ordinary personal injury is not on that list. A car collision, a slip and fall, a premises claim, a product liability claim, a medical malpractice claim: none of them fall within section 62(e). There is no above-the-line fee deduction for a standard injury case.
Punitive Damages and Interest
Punitive damages are always taxable. Section 104(a)(2) excludes damages “other than punitive damages,” and the IRS instructs that punitive damages are reported as Other Income on Schedule 1, line 8z, even when they were received in a settlement for personal physical injuries.
There is one narrow statutory exception at section 104(c) for wrongful death actions in states whose law, as of September 13, 1995, permitted only punitive damages in wrongful death. California is not such a state, because California allows compensatory wrongful death damages. The exception does not apply here.
Interest is taxable as interest income and is reported separately. In a case that took years, prejudgment and post-judgment interest can be a meaningful taxable component of an otherwise tax-free recovery.
The Medical Expense Recapture Trap
This one surprises people. If you deducted medical expenses related to the injury in a prior year, and that deduction actually reduced your tax, you must include the corresponding portion of the settlement in income when you receive it.
The limitation matters: recapture applies only to the extent the deduction provided a tax benefit. A claimant who took the standard deduction in the relevant year received no benefit from itemizing medical costs and is unaffected. If the deduction spanned multiple years, IRS guidance requires allocating the recaptured amount proportionally.
Why Settlement Allocation Deserves Attention
Because different components are taxed differently, how a settlement agreement characterizes the payment has real consequences. An agreement that lumps everything together, or that recites categories carelessly, can create a tax problem that careful drafting would have avoided.
This is a point to raise with your attorney before the agreement is signed, not after the 1099 arrives. It is also a point where a tax professional’s input is worth the cost on a larger recovery.
Do I pay taxes on my personal injury settlement?
Generally not on the portion compensating physical injuries or physical sickness, which is excluded under section 104(a)(2). You do pay tax on punitive damages, on interest, on emotional distress damages not tied to a physical injury, and on previously deducted medical expenses that gave you a tax benefit.
Can I deduct my attorney fees from a settlement?
Usually not, and usually it does not matter. If the recovery is excluded from income, there is nothing to deduct and nothing was taxed. On a taxable recovery, the miscellaneous itemized deduction that would have covered the fee is permanently suspended under section 67(h), so no deduction is available unless the claim falls within the narrow discrimination or whistleblower categories.
Did the attorney fee deduction come back in 2026?
No. The suspension was scheduled to expire after 2025 but was made permanent by the One Big Beautiful Bill Act in July 2025 and renumbered to section 67(h). Articles saying it expires after 2025 are out of date.
Are punitive damages taxable if my case was for physical injuries?
Yes. Section 104(a)(2) expressly excludes punitive damages from the exclusion, and the IRS instructs that they are reported as Other Income even when received in a physical injury settlement.
What about the medical bills I already deducted?
You must include that portion of the settlement in income, but only to the extent the earlier deduction actually reduced your tax. If you took the standard deduction that year, there is generally nothing to recapture.
This article discusses federal tax rules in general terms and is not tax advice. Tax treatment depends on the specific facts of your case and your overall tax situation. Consult a qualified tax professional about your circumstances.
If you are negotiating a settlement, how it is allocated is worth discussing before you sign. Learn more about personal injury claims, read about insurance claim disputes, or contact B&D Injury Law Group for a free consultation.
This article is provided for general informational purposes only and does not constitute legal advice. Reading it does not create an attorney-client relationship. Every case is different and past results do not guarantee a similar outcome. If you have been injured, speak with a licensed attorney about your specific situation.