Tax law provides that gross income includes all income from whatever source derived, including income arising from a settlement agreement. 26 U.S.C. §61(a). Any deductions or exclusions from this general rule are a matter of legislative grace, which means that Congress must have enacted a specific statute or regulation allowing a taxpayer to avoid reporting the full amount of income received. The Internal Revenue Code (“IRC” or “Code”) is voluminous and complex because it contains numerous exclusions, exceptions, and deductions defining how this “legislative grace” can be applied.
Taxability of Settlement Proceeds Generally
As stated above, Code section 61(a) provides the general rule that settlement proceeds are “gross income” subject to federal taxation. However, the main exclusion of litigation awards and settlement proceeds from income is found in Code section 104(a)(2), which excludes from gross income damages received on account of personal physical injuries and physical sickness. This covers amounts received through prosecution of a lawsuit or through a settlement agreement entered into in lieu of prosecution. See Treas. Reg. §1.104-1(c).
Typically, to be excluded, the damages suffered by the person claiming the exclusion must be both “personal” and “physical.” This means the person claiming the exclusion must have suffered the injury, and the injury must be manifested in a physical state. Mental or emotional distress is typically not a “physical” injury or sickness, although settlement payments for medical care for emotional distress may be excludible from income. See Treas. Reg. §1.104-1(c).
The Mennemeyer Case
The taxation of settlement proceeds was recently reviewed by the U.S. Tax Court in the matter Adrienne Mennemeyer v. Commissioner of Internal Revenue, T.C. Memo 2025-80. The Tax Court published its Memorandum Findings of Fact and Opinion on July 28, 2025, addressing whether the taxpayer’s settlement proceeds from an arbitration and lawsuit were taxable income.
In the case, Ms. Mennemeyer claimed that she was improperly fired and that her former employer, PNC, defamed her when it made a public filing with the Financial Industry Regulatory Authority (“FINRA”) stating she was terminated for dishonesty. FINRA conducted an arbitration, and ultimately awarded Ms. Mennemeyer $300,000 in damages to compensate her for the defamation and lost wages, and $1.5 million in punitive damages to punish PNC for its defamation. PNC appealed the arbitration award to the federal court, and thereafter the parties settled. As part of the settlement, PNC agreed to pay Ms. Mennemeyer a total of $1.51 million, which included a payment of $997,466 to Ms. Mennemeyer and a second payment of $512,534 to her attorneys for their legal fees.
On her personal income tax return for 2018, Ms. Mennemeyer reported $498,733 as her income from the settlement, which was half of the amount she received. She did not report the full amount of the settlement, nor the amount paid to her attorneys. The IRS audited her 2018 income tax return, determined that Ms. Mennemeyer should have reported the full $1.51 million settlement in her gross income, and assessed significant additional taxes and penalties totaling $870,739.
Ms. Mennemeyer appealed the IRS’s decision to the U.S. Tax Court, who considered whether Ms. Mennemeyer’s case fell under the Section 104(a)(2) exclusion for “personal physical injuries or physical sickness.” The Tax Court noted that Ms. Mennemeyer’s claim was originally related to her termination of employment with PNC Bank and defamation claims related to PNC’s FINRA filing. FINRA’s arbitration award was specifically for the “defamatory nature of the information” in PNC’s public filing, and the settlement agreement released claims related to Ms. Mennemeyer’s employment and PNC’s defamation. Although Ms. Mennemeyer attempted to raise physical ailments resulting from PNC’s actions, the Court did not agree that the claims, litigation, arbitration award, or settlement were based on the alleged ailments, nor was there sufficient evidence of any physical injury or sickness connected with PNC’s actions. As a result, the Tax Court concluded that the entire $1.51 million settlement proceeds were includible in Ms. Mennemeyer’s “gross income” under Code section 61(a), since the exclusion in section 104(a)(2) did not apply.
However, Ms. Mennemeyer also argued that the payment to her attorneys should be excluded under Code section 62(a)(20), which permits a deduction from gross income for “for attorneys fees and court cost paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination.” Section 62(e) defines the term “unlawful discrimination” to include an act which is unlawful under a variety of federal, state, or local laws, including a provision: “(i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits . . . .” 26 U.S.C. §62(e)(18). For various reasons the Tax Court found that Ms. Mennemeyer could deduct from gross income the portion of settlement proceeds paid to her attorneys.
The Lessons Learned
The Mennemeyer case reminds us that most settlement proceeds received are taxable, and the tax can greatly reduce the net amount received. The following example demonstrates the difference between the client’s expectation of settlement and the amount actually received:
| Settlement Proceeds | $250,000 |
| Federal income tax (32%) | ($57,000) |
| Illinois income tax (4.95%) | ($12,375) |
| Net amount retained by Plaintiff: | $180,625‡ |
‡Figures are estimated and based on assumptions such as applicable tax bracket and no offsetting deductions.
This means that, if an individual single claimant settles a claim for $250,000, they may pay around $57,000 in federal income taxes (plus any applicable state income tax) which reduces the overall value of the settlement. (This assumes they are in the 32% tax bracket for 2025 and have no other deductions). The net settlement amount after taxes would be only $193,000.
Mennemeyer also teaches us the importance of documenting the bases for exclusion of settlement proceeds from gross income. For example, had the taxpayer, from the beginning, consistently included her physical injuries in her claims and documented them well, a portion or all of her settlement proceeds might have been subject to the Code section 104(a)(2) exclusion. Had she suffered mental or emotional anguish and sought reimbursement for her medical costs, this portion could have been excluded. The documentation of physical illness or injury should ideally begin from the moment the claim is made, and continue consistently through any resolution, such as being documented in the settlement agreement as a component of the claim being resolved.
Mennemeyer also teaches us that hiring quality tax advisors is vital to achieving the best available result. In the case, Ms. Mennemeyer had used a CPA as her personal and business accountant, but she had a romantic relationship with him, which created a potential credibility issue when evidence was presented to the Tax Court. Additionally, had Ms. Mennemeyer hired a qualified and knowledgeable tax attorney, she would have learned that the settlement proceeds were taxable, and may have improved her settlement negotiations had she known the tax laws earlier in her dispute.
Conclusions
The taxability of settlement proceeds should be a consideration whenever any litigant or claimant is negotiating a settlement, since it affects the value of the amount received. Engaging a tax professional early in the process may be helpful to clarify what portion of a proposed settlement will be taxable or to structure a settlement to minimize taxes on the proceeds. The Internal Revenue Code is complex because it contains numerous exclusions, exceptions, deductions, and exceptions to the exceptions. Deciphering applicable tax laws and applying them to a particular set of facts can be difficult and time-consuming.
Also important is negotiating and drafting a settlement agreement that maximizes any tax-savings from applicable exclusions or deductions. For example, a settlement agreement can include references to the parties’ intent in making the settlement, which can help the party receiving the funds fall within a particular exclusion or deduction in the Internal Revenue Code. A particular provision can identify the type of claims being settled to include “personal physical injury” or “physical sickness,” or specify which portion of the settlement proceeds are allocated to attorneys’ fees. A provision might also specify the type of claims being released such as “employment-related” to fall under a particular deduction. If the IRS audits a taxpayer’s income tax return, the settlement agreement may be the key document governing whether the payments are excludable or deductible.
Finally, it is important to note that the party making the payment may also be obligated to report the potentially-taxable settlement payment to the IRS, through a Form 1099 or other applicable tax form. A tax professional can assist in determining which specific form type is needed.
Sandra Mertens
smertens@gcklegal.com