If you are an individual taxpayer who receives a lawsuit settlement, part of that settlement may go directly to your attorney.
But for tax purposes, the amount you actually put in your pocket is not necessarily the amount that matters.
A 2025 U.S. Tax Court case, Mennemeyer v. Commissioner, T.C. Memo. 2025-80, shows why.
The issue becomes much easier to understand if we ask two questions, in order.
Question #1: Is the Settlement Itself Taxable?
Before worrying about attorney fees, determine whether the settlement itself is taxable.
Settlement proceeds that may be nontaxable
Certain compensatory damages received on account of personal physical injuries or physical sickness may be excluded from taxable income.
Examples may include qualifying compensatory damages arising from:
- Physical injuries from a car accident;
- Physical injuries caused by medical malpractice;
- Physical injuries resulting from an assault; or
- Physical injuries from a slip-and-fall accident.
Settlement proceeds that are generally taxable
Examples may include:
- Lost wages or back pay;
- Employment discrimination damages representing taxable economic or nonphysical damages;
- Defamation damages;
- Emotional-distress damages not attributable to physical injury or physical sickness; and
- Punitive damages.
So our first question is simple:
Is the settlement taxable?
If the answer is yes, we proceed to Question #2.
Question #2: If the Settlement Is Taxable, Can You Deduct the Attorney Fees?
Now assume that both individuals have taxable settlements.
We will compare two specific taxable claims:
| COLUMN #1 — Employment Discrimination Claim | COLUMN #2 — Personal Defamation Claim Unrelated to Employment |
| The individual receives a taxable settlement from a qualifying employment discrimination claim. | The individual receives a taxable settlement from a personal defamation claim unrelated to employment. |
| Federal law may allow the individual to deduct qualifying attorney fees under the special rule for certain employment and civil-rights claims. | The claim does not qualify for that special attorney-fee deduction merely because attorney fees were paid. |
Why does that distinction matter?
Let’s put numbers on it.
Two Individuals — Same Settlement, Same Attorney Fee, Different Tax Result
Assume each individual receives a $500,000 taxable settlement.
Each pays $175,000 to an attorney.
Each therefore actually receives only $325,000.
| COLUMN #1 — Employment Discrimination | COLUMN #2 — Personal Defamation Unrelated to Employment | |
| Total taxable settlement | $500,000 | $500,000 |
| Attorney receives | $175,000 | $175,000 |
| Cash actually received by taxpayer | $325,000 | $325,000 |
| Question #1: Is the settlement taxable? | YES | YES |
| Amount initially included in income | $500,000 | $500,000 |
| Question #2: Does the special attorney-fee deduction apply? | YES* | NO* |
| Attorney-fee deduction | ($175,000) | $0 |
| BOTTOM LINE — Amount remaining taxable from the settlement in this simplified example | $325,000 | $500,000 |
*Assuming all applicable statutory requirements are satisfied.
The difference is substantial.
Both individuals received only $325,000.
But the individual in Column #1 has $325,000 remaining taxable after the special attorney-fee deduction.
The individual in Column #2 received the same $325,000 in cash but may have the entire $500,000 taxable, because the $175,000 paid to the attorney does not qualify for this special deduction.
What Did the Tax Court Decide in Mennemeyer?
Adrienne Mennemeyer received a $1.51 million settlement arising from claims connected with her former employment. Of that amount, $512,534 went to her attorneys.
The Tax Court essentially worked through the same two questions.
Question #1 — Was the settlement taxable?
Yes. The settlement was not shown to have been paid on account of personal physical injuries or physical sickness. The settlement therefore did not qualify for that exclusion from income.
Question #2 — Could the attorney fees qualify for the special deduction?
Yes. The Tax Court concluded that Mennemeyer’s employment-related claims fell within the statutory provisions covering certain claims involving the employment relationship.
That meant the attorney fees could be considered for the special deduction in determining her tax liability.
The Practical Lesson
Mennemeyer demonstrates that an individual receiving a lawsuit settlement should ask two separate tax questions:
Is my settlement taxable?
And, if it is:
Can I deduct the attorney fees?
Those are different questions.
Two individuals can have the same $500,000 taxable settlement, pay the same $175,000 attorney fee, and receive the same $325,000 in cash—yet potentially have very different amounts remaining taxable because their underlying legal claims are different.
For a substantial settlement, these tax issues should ideally be considered before the settlement agreement is signed, not for the first time when the tax return is being prepared.
As both a CPA and Tax Attorney, I can analyze both sides of a settlement-tax issue: the proper tax treatment and reporting of the settlement and the legal authorities supporting that treatment if the IRS later questions the taxpayer’s position.
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This article is for general educational purposes only and does not constitute legal or tax advice. The taxation of settlement proceeds and attorney fees depends on the underlying claims, settlement language, allocation of damages, fee arrangement, and other facts and circumstances.