The money you get from selling settlement assets is sometimes a capital gain, but it is usually taxed as ordinary income. The final answer depends entirely on what the original settlement money was meant to replace. If it replaced lost wages, it’s ordinary income; if it compensated you for damage to an investment property, it could be a capital gain.
The primary conflict stems from a foundational rule in the U.S. tax code. Internal Revenue Code (IRC) Section 61 defines gross income as “all income from whatever source derived,” making nearly all money you receive taxable by default. This creates a direct clash where the IRS presumes your settlement is ordinary income, forcing you to pay taxes at rates up to 37%, while you hope to prove it qualifies for the lower capital gains rates of 0%, 15%, or 20%.
This distinction is not trivial. For every $100,000 of a taxable settlement, the difference between being taxed at the highest ordinary income rate versus the most common long-term capital gains rate can be over $22,000 in federal taxes alone.
Here is what you will learn by reading this guide:
- 💰 How to tell the difference between ordinary income and a capital gain, and why it dramatically changes your tax bill.
- ⚖️ The single most important legal test the IRS uses, called the “origin of the claim,” to decide how your settlement is taxed.
- 🛡️ How to use the tax code to your advantage by framing a business lawsuit around damage to a capital asset like “goodwill.”
- đźš« The critical mistakes that can accidentally turn a tax-free settlement into a taxable nightmare.
- đź’ˇ An advanced, high-risk strategy that treats your entire lawsuit as a sellable asset to potentially achieve capital gains.
The Two Worlds of Taxation: Ordinary Income vs. Capital Gains
The U.S. tax system has two basic ways of looking at money you make. Think of them as two separate worlds with completely different rules and, most importantly, different tax rates. Understanding which world your settlement money lives in is the first step to knowing how much you will keep.
World #1: The Land of Ordinary Income
This is the world most people are familiar with. Ordinary income is money you earn from your job, profits from a business you run, or interest you get from a savings account. The government taxes this income at progressive marginal rates, meaning the more you make, the higher the percentage you pay on parts of that income, with federal rates climbing as high as 37%.
World #2: The Realm of Capital Gains
This world is for profits made from your investments. A capital gain happens when you sell something valuable—called a capital asset—for more than you originally paid for it. The IRS defines a capital asset as almost anything you own for personal use or investment, like stocks, bonds, a piece of art, or a second home.
The tax magic happens with long-term capital gains. If you own a capital asset for more than one year before selling it, you unlock special, lower tax rates. Depending on your total income, you could pay 0%, 15%, or 20% in federal tax on your profit, which is significantly less than ordinary income rates.
| Feature | Ordinary Income | Long-Term Capital Gains | | :— | :— | | What It Is | Money from wages, business profits, interest. | Profit from selling an investment held over one year. | | Top Federal Tax Rate (2024) | 37% | 20% (plus a potential 3.8% NIIT) | | Common Examples | Salary, consulting fees, rent payments. | Selling stocks, real estate, or a business. |
The IRS’s Golden Rule: What Was the Money Supposed to Replace?
When the IRS looks at a settlement check, it asks one simple but powerful question: “In lieu of what were the damages awarded?“. This is the core of the “origin of the claim” doctrine, a legal test that says the tax treatment of your settlement money must match the tax treatment of the money you would have received if there had been no lawsuit.
The way your lawyer writes the very first court document—the complaint—can lock in the tax consequences years down the road. The IRS considers the initial lawsuit filings to be the most compelling evidence of what the money is truly for.
Why Most Business Settlements End Up as Ordinary Income
Most business lawsuits are filed to recover money that would have been ordinary income anyway. If a supplier breaks a contract and you sue for the lost profits you would have made, the settlement is a substitute for those profits. Since business profits are ordinary income, the settlement is taxed as ordinary income.
The same rule applies to lawsuits over unpaid professional fees, royalties, or interest. The settlement money simply takes the place of the original taxable income, so it gets the same tax treatment.
The Golden Ticket: Proving Damage to a Capital Asset
The biggest exception to the ordinary income rule is when your lawsuit is about damage to a capital asset. Imagine your business has a stellar reputation, known as “goodwill.” Goodwill is an intangible capital asset. If a competitor’s actions damage that goodwill, and you sue for the loss in its value, the settlement is treated very differently.
The money you receive is first considered a tax-free “return of capital” up to your “basis” (your investment cost) in that asset. Any amount you receive above your basis is then taxed as a capital gain. This is why the language in the final settlement agreement is so critical; explicitly allocating the payment to “damage to business goodwill” can save a fortune in taxes, as long as it reflects the reality of the dispute.
The One True Tax-Free Zone: Physical Injury Settlements
Congress created a special safe harbor for certain settlements. Under IRC §104(a)(2), money you receive for personal physical injuries or physical sickness is completely tax-free. This rule is powerful and broad.
It covers not just payments for pain and suffering but also any economic damages, including lost wages, that are a direct result of that physical injury. The key is an observable, physical harm. Settlements for purely emotional distress, defamation, or discrimination are generally taxable as ordinary income unless the distress was caused by a physical injury.
Cashing Out Early: The “Substitute for Ordinary Income” Trap
What if you win a settlement that pays out over 20 years, but you want the cash now? You might sell the right to those future payments to a company for a lump sum. While this looks like the sale of an asset, the IRS has a powerful argument to turn what you hope is a capital gain back into ordinary income.
This argument is called the “substitute for ordinary income” doctrine. It says you cannot change the tax character of money just by selling your right to receive it. If the future payments were going to be ordinary income (like lottery winnings or taxable settlement payments), the lump sum you get for selling them is just an early payment of that same ordinary income.
The most famous case on this is Watkins v. C.I.R., where a lottery winner sold his future annual payments for a lump sum. The court ruled that the lump sum was a substitute for the future lottery winnings, which are taxed as ordinary income. The sale didn’t create a capital gain; it just sped up the receipt of ordinary income that was already earned.
Real-World Battles: Three Scenarios Showing How the Rules Play Out
These abstract rules become much clearer when applied to real-life situations. Here are three common scenarios that show how legal strategy and tax law intersect, with dramatically different financial outcomes.
Scenario 1: The Business Lawsuit
A company, “Innovate Corp,” sues a competitor for stealing a trade secret, which crippled its new product launch. The final tax bill depends entirely on how Innovate Corp’s lawyers framed the case from the very beginning.
| Legal Strategy | Tax Outcome |
| The “Lost Profits” Argument: The lawsuit demands $10 million for the profits Innovate Corp would have made. The case settles for $7 million. | Ordinary Income. The $7 million is a substitute for business profits. It will be taxed at ordinary income rates, potentially as high as 37%. |
| The “Damaged Goodwill” Argument: The lawsuit demands $10 million for the destruction of Innovate Corp’s business goodwill and brand reputation (a capital asset). The settlement agreement specifically allocates the $7 million to “damage to goodwill.” | Capital Gain. The payment is first a tax-free return of any basis Innovate Corp has in its goodwill. The rest is taxed at the lower long-term capital gains rates. |
Scenario 2: The Personal Injury Settlement
Maria was in a car accident and received a tax-free structured settlement paying her $3,000 per month for life under IRC §104(a)(2). Five years later, she needs a $75,000 lump sum for a down payment on an accessible home. She decides to sell a portion of her future payments to a “factoring company.”
This process is heavily regulated by both federal and state law to protect people like Maria. The key law is IRC §5891, which imposes a massive 40% excise tax on the factoring company’s profit unless a state court judge approves the sale. This tax isn’t for revenue; it’s a penalty designed to force the transaction into a courtroom, where a judge must decide if the sale is in Maria’s “best interest”.
| Action Taken | Legal & Tax Consequence |
| Maria Sells Payments Without Court Approval: A predatory company convinces Maria to sign papers without going to a judge. | Buyer Pays 40% Tax. The factoring company is hit with the 40% excise tax on its profit. Maria’s lump sum is still tax-free, but the deal was likely unfair. |
| Maria Sells Payments With Court Approval: Maria works with a reputable company. A judge reviews the discount rate and her reason for needing the money, then issues a “qualified order” approving the sale. | No Tax for Anyone. The factoring company avoids the 40% tax. Because the original settlement was for a physical injury, the lump sum Maria receives is completely tax-free. |
Scenario 3: The High-Stakes Gamble: Selling Your Lawsuit as a Capital Asset
This is an advanced and aggressive strategy. Instead of waiting for a settlement, some plaintiffs try to sell their entire legal claim—the right to sue itself—to a third-party litigation finance company. The legal term for this right is a “chose in action,” which is a form of intangible property.
The argument is that you are not selling future income; you are selling a capital asset (the chose in action) today. By analogy, when you sell a stock, you get a capital gain, even though the stock itself produces ordinary income through dividends. This strategy attempts to do the same with a lawsuit, but it is very likely to be challenged by the IRS.
| Strategic Move | Potential IRS Challenge |
| Early Sale of the Claim: Soon after filing a breach of contract lawsuit (which would normally produce ordinary income), the plaintiff sells the entire claim to a litigation funder for $1 million. | “Assignment of Income.” The IRS will argue this is a disguised arrangement to get paid early. They will likely use the “substitute for ordinary income” doctrine to reclassify the $1 million as ordinary income. |
| Sale After a Favorable Judgment: The plaintiff wins at trial, and the defendant is ordered to pay. The plaintiff then sells the right to collect that judgment. | Almost Certain Ordinary Income. At this point, the income is essentially earned and fixed. The sale is almost identical to selling a lottery ticket and will be taxed as ordinary income. |
The Seller’s Playbook: Navigating a Structured Settlement Sale
Deciding to sell your guaranteed, tax-free structured settlement payments is a major financial decision that should never be taken lightly. You are trading long-term security for immediate cash, and you will always receive less money than the total face value of the payments you sell.
Weighing the Pros and Cons of Selling
| Pros | Cons |
| Immediate Liquidity: Get a large lump sum of cash quickly for urgent needs. | You Get Less Money: The lump sum is discounted, meaning you forfeit a significant portion of the total value. |
| Pay Off High-Interest Debt: Use the cash to eliminate costly credit card or medical debt. | Loss of Long-Term Security: You give up a guaranteed, stable, and tax-free income stream. |
| Major Life Investments: Fund a down payment on a home, education, or a business startup. | Risk of Mismanagement: A sudden windfall can be spent quickly without proper financial planning. |
| Financial Flexibility: Gain control over your money to invest it as you see fit. | The Process Takes Time: Getting court approval and your money can take 45 to 90 days. |
Decoding the Discount Rate: Why You Get Less Than Face Value
Factoring companies are not charities; they are finance companies in business to make a profit. They buy your future payments at a discount. This “discount rate” is like an interest rate they charge for giving you your money early.
These rates typically range from 9% to over 18%. The rate depends on how many payments you are selling and how far into the future they are. The further out the payment, the less it is worth today, and the deeper the discount will be.
The Judge’s Approval: Your Shield Against Predatory Deals
The court approval process is your most important protection. A judge is required by state law, known as a Structured Settlement Protection Act (SSPA), to review the transaction.
The judge’s primary job is to determine if the sale is in your “best interest,” considering the welfare of your dependents. They will look at:
- Your reason for needing the money.
- The fairness of the discount rate.
- Whether you have received independent professional advice.
- Whether you understand the long-term consequences of the sale.
Common & Costly Mistakes to Avoid
Navigating the world of settlements and taxes is filled with traps. A single misstep, often made early in the process, can have irreversible and expensive consequences. Here are some of the most critical errors to avoid.
Mistake #1: Signing an “All Cash” Release
When settling a case, the defense will present a release document to sign. If this document says it is an “all cash” settlement, it can immediately make the entire amount taxable, even if you intended to structure it for tax-free payments. This language triggers “constructive receipt,” meaning the IRS views you as having received all the money at once.
Mistake #2: Depositing Settlement Funds into Your Lawyer’s Trust Account First
This is the one mistake that is almost impossible to fix. For a structured settlement to be tax-free (or tax-deferred for attorney fees), the defendant must use the settlement funds to purchase the annuity for you. If the money first goes into your or your attorney’s bank account, you have taken ownership of it. Any annuity you buy after that is just a personal investment, and the earnings will be taxable.
Mistake #3: Falling for a “Forum Shopping” Scheme
Every state has laws protecting settlement sellers, but some states have stricter judges than others. “Forum shopping” is an illegal practice where a factoring company convinces you to temporarily relocate or file your sale petition in a state with weaker consumer protection laws to get a high-discount deal approved more easily. The law is clear: the transfer petition must be filed in the state where you actually live.
Frequently Asked Questions (FAQs)
1. Is money from a lawsuit always taxable? No. Money for a personal physical injury or sickness is tax-free under IRC §104(a)(2). Most other settlements, such as for lost wages or business profits, are taxable as ordinary income.
2. What is the difference between ordinary income and capital gains? Ordinary income is from wages or business profits and is taxed at higher rates. Capital gains are profits from selling an investment held for over a year and are taxed at lower, preferential rates.
3. If my settlement is for emotional distress, is it tax-free? No, not usually. Settlements for emotional distress are taxable unless the distress was directly caused by a physical injury. Without a physical injury, the money is considered ordinary income.
4. Are punitive damages taxable? Yes. Punitive damages, which are meant to punish the defendant rather than compensate you, are almost always taxable as ordinary income, even if they are part of a physical injury settlement.
5. If I sell my tax-free structured settlement, is the lump sum I get taxable? No. If the original settlement was for a physical injury, the lump sum you receive from a court-approved sale keeps its tax-free status. It is seen as an early payment, not new income.
6. Why does a judge have to approve the sale of my settlement payments? To protect you. Federal law imposes a 40% tax penalty on the buyer unless a judge finds the sale is in your “best interest.” This prevents predatory companies from taking advantage of sellers.
7. What is a typical discount rate when selling my payments? Discount rates typically range from 9% to 18% but can be higher. The rate reflects the buyer’s profit and depends on how far in the future the payments are scheduled to be made.
8. Can I sell just a portion of my settlement payments? Yes. You can sell payments for a specific period (like the next five years), sell a percentage of each payment, or sell a specific lump sum payment scheduled for the future. This is called a partial sale.
9. I won the lottery. If I sell my future payments, is it a capital gain? No. Courts have consistently ruled that selling future lottery winnings results in ordinary income. The lump sum is considered a “substitute for ordinary income” because the original winnings were ordinary income.
10. What is a “chose in action”? It is a legal term for an intangible property right to bring a lawsuit. Some people argue that selling this right itself should be treated as the sale of a capital asset, but this is a very aggressive tax position.