Most Settlement Proceeds Are Taxable, And the Ninth Circuit Just Reminded Everyone Why

If you recently settled a lawsuit and assumed the proceeds were tax-free, the Ninth Circuit has a message for you: they probably are not. In Roman v. Commissioner, decided March 18, 2026, the Ninth Circuit affirmed the Tax Court's ruling that settlement proceeds from a housing-related dispute were fully taxable because the taxpayer failed to prove the payments were made on account of personal physical injuries or physical sickness. The decision is a sharp reminder that the exclusion under IRC § 104(a)(2) is far narrower than most people realize, and that the consequences of getting it wrong extend beyond the tax itself to accuracy-related penalties under IRC § 6662.

Let us start with the rule itself. Under IRC § 104(a)(2), damages received on account of personal physical injuries or physical sickness are excluded from gross income. That statutory language, "on account of", is doing a tremendous amount of heavy lifting. It is not enough that a taxpayer was physically hurt at some point during the events giving rise to the lawsuit. It is not enough that the taxpayer experienced physical symptoms from the stress of the litigation. The payment itself must be directly traceable to the physical injury or physical sickness. If the underlying claim sounds in contract, employment discrimination, emotional distress, or any other theory that does not have a physical injury at its core, the exclusion does not apply.

This is what courts call the origin-of-the-claim test, and it has been the controlling framework for decades. The test asks a deceptively simple question: in lieu of what were the damages paid? If the answer is "in lieu of compensation for a broken arm suffered in a slip-and-fall," the exclusion applies. If the answer is "in lieu of lost wages from a wrongful termination," the proceeds are taxable as ordinary income. The label the parties put on the payment in the settlement agreement matters, but it is not dispositive. Courts look at the underlying claim, the complaint, the factual record, and the nature of the injury alleged, not just the words the lawyers negotiated into the release.

In Roman, the taxpayer received settlement proceeds arising from housing-related disputes. The taxpayer argued that the payments should be excluded because physical health problems were connected to the living conditions at issue. That argument failed at both levels. The Tax Court found, and the Ninth Circuit affirmed, that the taxpayer did not establish a direct link between the settlement payment and any qualifying personal physical injury or physical sickness. The record simply did not support it. There was no medical evidence tying the payment to a physical injury. The claims as pleaded did not seek damages for physical injury. The settlement agreement did not allocate proceeds to physical injury claims. Without that evidentiary foundation, the exclusion was unavailable.

What makes Roman particularly instructive is the penalty analysis. The taxpayer not only owed tax on the settlement proceeds but also faced accuracy-related penalties under IRC § 6662. The penalty for a substantial understatement is twenty percent of the underpayment, on top of the tax itself, plus interest running from the original due date. The only way to avoid the penalty is to demonstrate reasonable cause and good faith, which typically requires showing reliance on the advice of a qualified tax professional. If you excluded settlement proceeds from income without getting a professional opinion that the exclusion was legally supportable, you are exposed on both the tax and the penalty.

This brings us to the practical question that business owners, plaintiffs, and their attorneys need to understand: how do you protect a settlement exclusion before the return is filed? The answer starts long before the settlement agreement is signed. In fact, it starts at the pleading stage.

If you are a plaintiff and you believe your case involves a genuine physical injury, the complaint needs to say so. The claims need to seek damages for personal physical injuries or physical sickness. You need contemporaneous medical records documenting the physical injury, not records generated after the settlement for the purpose of supporting a tax position. The treating physician's records from the time of the injury are what matters. If the complaint alleges emotional distress, breach of contract, or employment discrimination, and physical injury is not mentioned until the settlement negotiations, courts will see through that.

The settlement agreement itself is critical. A well-drafted agreement will specifically allocate portions of the payment among different categories of damages. It will identify which claims are being resolved and what portion of the payment is attributable to each. It will tie the allocation to the factual record, the medical bills, the physical injury documentation, the nature of the claims as pleaded. An allocation that does not match the underlying facts will not survive IRS scrutiny. The IRS is not bound by the parties' characterization of the payment. If the allocation appears self-serving or inconsistent with the litigation record, the Service can and will recharacterize the payment.

Employment settlements deserve special attention because they are almost always taxable. Back pay and front pay are wages, reportable on Form W-2 and subject to FICA. Non-wage components of an employment settlement, emotional distress damages, for example, are reported on Form 1099-MISC or 1099-NEC and are taxable as ordinary income. Legal fees paid directly to the plaintiff's attorney are still included in the plaintiff's gross income, though an above-the-line deduction may be available under IRC §§ 62(a)(20) and (21) for certain claims involving unlawful discrimination or whistleblower actions. But the deduction is limited, and it does not change the fundamental character of the payment.

Punitive damages are always taxable, with one narrow exception. Under IRC § 104(c), punitive damages received in a wrongful death action may be excluded if the applicable state law provides that only punitive damages may be awarded in such an action. That exception applies in only a handful of states and in very specific circumstances. For the vast majority of litigants, punitive damages are ordinary income, period.

Emotional distress damages present one of the most commonly misunderstood areas. Standing alone, emotional distress is not a physical injury for purposes of § 104(a)(2). The 1996 amendments to the statute made that clear. If the emotional distress is caused by a physical injury, for example, anxiety and depression resulting from a car accident that broke the plaintiff's spine, then the damages attributable to the emotional distress may be excluded as part of the physical injury recovery. But if the emotional distress is the primary claim, and the physical symptoms are secondary manifestations of that distress, insomnia, headaches, weight loss from stress, the exclusion does not apply. Medical expenses incurred to treat emotional distress may be deductible under IRC § 213, but they are not excludable under § 104(a)(2).

The takeaway from Roman is not complicated, but it is important. The default rule is that settlement proceeds are taxable income. The exclusion under § 104(a)(2) is an exception to that default, and the burden of proving entitlement to the exception falls entirely on the taxpayer. If you are negotiating a settlement with any potential tax-free component, the time to think about the tax treatment is before the agreement is signed, not when you are sitting in front of your CPA during tax season wondering why your 1099 is so large.

For plaintiffs, this means having the tax conversation with your attorney early in the case, ideally at the pleading stage. Make sure your claims are properly framed if physical injury is genuinely at issue. Gather your medical documentation. When the settlement is negotiated, insist on specific allocations that are consistent with the factual record.

For defendants and their counsel, settlement allocations matter too. A defendant who agrees to allocate an entire payment to "physical injury damages" when the complaint only alleged breach of contract is creating a document that will not withstand scrutiny, and potentially exposing the plaintiff to penalties when the IRS disagrees with the characterization.

For tax advisors, Roman is a reminder to document your analysis. If a client comes to you with a settlement and asks whether it is excludable, the answer should be based on a review of the complaint, the settlement agreement, the medical records, and the litigation record, not just the client's description of what happened. If the exclusion is supportable, memorialize that conclusion in a written opinion. If it is not, say so clearly. The worst outcome is a client who excludes a taxable settlement from income, gets hit with an accuracy-related penalty, and has no professional opinion to fall back on.

The Ninth Circuit's decision in Roman v. Commissioner did not break new legal ground. It applied the same origin-of-the-claim framework that has governed this area for years. But it is a useful reminder that the framework is strictly enforced, and that courts will not stretch § 104(a)(2) to cover payments that do not clearly compensate for personal physical injuries or physical sickness. If you are dealing with a settlement, on either side of the table, get the tax analysis right before the ink dries.