Tax Treatment of Business Litigation: Settlements, Attorney Fees, and Damages

By Yarik Yarosh, CPA ·September 5, 2026 ·7 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Business litigation creates tax issues on both sides of the courtroom. Under the origin of the claim doctrine (from Gilmore, 372 U.S. 39 (1963)), the tax character of any amount received or paid in litigation is determined by looking at the nature of the claim that gave rise to the payment, not the form of the payment itself. This means a $1 million settlement payment could be ordinary income, capital gain, tax-free, or partially each, depending on the claims being settled. For the party paying the settlement, the deductibility depends on whether the payment relates to the taxpayer’s trade or business (IRC 162), constitutes a capital expenditure (IRC 263), or falls under the IRC 162(f) prohibition against deducting fines and penalties. Attorney fees follow similar rules: fees incurred in connection with the taxpayer’s trade or business are deductible under IRC 162, while fees related to investment activities or tax matters have been subject to changing rules, particularly after the TCJA’s suspension of miscellaneous itemized deductions through 2025.

✓Key takeaway

Tax treatment of damages received (recipient’s perspective):

Type of Damages	Tax Treatment	Authority
Compensatory damages for lost business profits	Ordinary income	Origin of claim doctrine
Compensatory damages for lost capital assets	Capital gain or loss	Origin of claim doctrine
Damages for physical injury or physical sickness	Excluded from income	IRC 104(a)(2)
Emotional distress damages (no physical injury)	Taxable as ordinary income	IRC 104(a), as amended
Punitive damages	Always ordinary income	IRC 104(a) (exception for wrongful death in some states)
Interest on judgment	Ordinary income	IRC 61
Damages for breach of contract (lost profits)	Ordinary income	Origin of claim
Damages for property destruction	Return of capital up to basis; gain above basis	IRC 1001
Damages for patent infringement	Ordinary income (lost royalties) or capital gain (lost sales depending on structure)	Origin of claim
Damages for employment discrimination (back pay)	Ordinary income (W-2 wages)	IRC 104(a)

Tax treatment of settlement payments (payer’s perspective):

Type of Payment	Deductible?	Authority
Settlement of business dispute (breach of contract, tort)	Yes (IRC 162, ordinary and necessary)	Deductible as business expense
Settlement of employment claim (discrimination, wrongful termination)	Yes (IRC 162)	Deductible as business expense
Settlement with non-disclosure agreement (NDA) for sexual harassment	No	IRC 162(q) (TCJA provision)
Fine or penalty paid to government	Generally no	IRC 162(f)
Restitution or remediation paid to government	May be deductible	IRC 162(f)(2) exception
Payment for acquisition of property or rights	No (capitalized)	IRC 263
Payment to defend title to property	No (capitalized)	Woodward v. Commissioner

How are business litigation proceeds and costs taxed?

Hypothetical example

Round numbers. For current guidance, see IRS Publication 535 (Business Expenses). A business sues a former partner for breach of a non-compete agreement and theft of trade secrets. The case settles for $2,000,000.

Settlement allocation (critical for tax purposes): The settlement agreement allocates the $2,000,000 as follows:

Claim	Amount	Tax Treatment to Recipient
Lost business profits (breach of non-compete)	$800,000	Ordinary income
Compensatory damages for stolen trade secrets (capital asset)	$500,000	Capital gain (long-term if asset held over 1 year)
Punitive damages	$400,000	Ordinary income
Emotional distress (no physical injury)	$100,000	Ordinary income
Attorney fee reimbursement	$200,000	Offset against attorney fees paid (depends on structure)
Total	$2,000,000

Tax calculation for recipient:

Component	Amount	Tax Rate	Tax
Ordinary income ($800K + $400K + $100K)	$1,300,000	37%	$481,000
Capital gain ($500K)	$500,000	20% + 3.8% NIIT	$119,000
Total tax on settlement			$600,000
After-tax proceeds			$1,400,000

Why the allocation matters: If the entire $2,000,000 had been allocated to lost profits (ordinary income): | Tax | $2,000,000 x 37% = $740,000 | | After-tax | $1,260,000 |

By properly allocating $500,000 to capital gain treatment, the recipient saves $140,000 in tax.

Attorney fees for the recipient:

Fee Arrangement	Deductibility
Fees related to trade or business claim	Deductible on Schedule C or as business expense (IRC 162)
Fees for employment discrimination claim	Deductible “above the line” under IRC 62(a)(20) (up to amount of judgment/settlement)
Fees for investment-related claim	Not deductible 2018-2025 (TCJA suspended miscellaneous itemized deductions)
Contingency fee arrangement	Attorney’s portion of settlement may be included in income under the assignment of income doctrine (Banks v. Commissioner, 543 U.S. 426 (2005)); above-the-line deduction available for certain claims

Payer’s perspective (the former partner paying $2,000,000):

Payment Component	Deductible?
Business-related compensatory damages	Yes (IRC 162, ordinary business expense)
Punitive damages	Yes (if related to trade or business; only government fines are non-deductible under 162(f))
Personal-origin claims	Not deductible (personal expense)
Non-compete violation damages	Yes (if paid in connection with trade or business)

IRC 162(f) fines and penalties rule:

What is NOT deductible	What IS deductible
Civil fines paid to government	Restitution payments (IRC 162(f)(2)(A))
Criminal fines and penalties	Remediation of property (IRC 162(f)(2)(B))
Environmental penalties (EPA, state)	Compliance costs imposed by government
OSHA penalties	Court costs
Tax penalties (accuracy, fraud, late filing)

IRC 162(q) sexual harassment NDA rule (TCJA):

Rule	No deduction allowed for:
Settlement payments	Related to sexual harassment or abuse if the settlement includes a non-disclosure agreement (NDA)
Attorney fees	Related to such a settlement are also non-deductible
Effect	Removes the tax benefit of settling with an NDA; applies to settlements paid or incurred after December 22, 2017

Structured settlements (IRC 104(a)(2)): For physical injury claims, a structured settlement (periodic payments rather than lump sum) has additional benefits:

Feature	Lump Sum	Structured Settlement
Excludable from income	Yes (physical injury)	Yes (physical injury)
Investment earnings	Taxable	Tax-free (included in the exclusion)
Creditor protection	None (once received)	Generally protected from creditors
Discipline	Lump sum available immediately	Payments over time

Contingency fee tax trap: Under Banks v. Commissioner (2005), even if the attorney takes 40% of a $2,000,000 settlement under a contingency fee arrangement, the full $2,000,000 is income to the plaintiff, and the $800,000 attorney fee is a deduction. If the deduction is below-the-line (not a business or employment discrimination claim), the plaintiff may not be able to deduct it at all (2018-2025 under TCJA), creating a tax on money the plaintiff never received.

Scenario	Income Reported	Deduction Available	Net Tax on Attorney’s Share
Business claim (IRC 162)	$2,000,000	$800,000 (above the line)	$0
Employment discrimination (IRC 62(a)(20))	$2,000,000	$800,000 (above the line, up to settlement)	$0
Personal claim (non-physical)	$2,000,000	$0 (miscellaneous deduction suspended)	$296,000 (37% of $800,000)

Illustrative numbers only, not a real client and not advice for your facts.

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Cite this page

Yarik Yarosh, CPA. "Tax Treatment of Business Litigation: Settlements, Attorney Fees, and Damages." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-tax-litigation-settlements-attorney-fees-deductions

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.

Tax Treatment of Business Litigation: Settlements, Attorney Fees, and Damages

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