Ever wondered if that settlement you received for lost profits is going to cost you at tax time? If you’ve been awarded money because your business lost profits due to someone else’s actions, you need to know how the IRS treats these payments. In this guide, you’ll learn if a lost profits award is taxable, how the IRS looks at these settlements, and what practical steps you should take next.

What Is a Lost Profits Award?

A lost profits award is money you receive when a court or settlement says someone else is responsible for income your business should have earned but didn’t. Let’s say you run a bakery, and a supplier fails to deliver flour for three months. Because of this, you couldn’t bake and sell goods, losing out on sales you would have made. If you sue the supplier and the court orders them to pay you for those missed sales, that’s a lost profits award.

This kind of payment is different from damages for property damage (like if someone crashes a car into your shop), or for personal injuries. The IRS treats each of these types of payments differently. Lost profits awards are focused on replacing income you missed due to another party’s actions, not repairing property or compensating for physical harm.

Lost profits awards might show up in all sorts of industries. A construction company might get one if a project was delayed because someone else broke a contract. A freelance designer could win lost profits if a client cancels a big job at the last minute in violation of their agreement. The key is that the payment is meant to make up for money your business should have earned, but didn’t.

Is a Lost Profits Award Taxable Income?

Let’s get right to the answer: yes, most of the time, a lost profits award is taxable income. The IRS treats these payments as a replacement for the income your business would have earned if things had gone normally. Since business income is taxable, the money you get from a lost profits award is usually taxed in the same way.

Think of it like this: if your business had earned the money through sales, you would have reported it as revenue and paid taxes on it. The fact that you got the money through a lawsuit or settlement doesn’t change its basic character. So, for tax purposes, lost profits awards are almost always taxed just like the business income they replace. If you receive $50,000 in a lost profits settlement, it’s as though your business earned an extra $50,000 in sales that year, and you’ll need to report and pay taxes on it.

There are rare exceptions. If a settlement is for something like physical injuries or sickness, it’s often not taxable. But lost profits are about replacing business income, and that’s taxable in nearly every case. Always double-check with a tax professional if you’re not sure your award fits the typical pattern.

How the IRS Views Lawsuit Settlements

The IRS has clear rules about lawsuit settlements. It looks at the reason you’re getting paid, not just the fact that it’s a settlement. If the payment is for lost business profits, it’s considered ordinary income. This means you’ll need to report it on your tax return and pay tax on it at your usual rate.

The IRS doesn’t care whether you call it a “settlement,” “award,” or “damages.” What matters is why you’re getting the money. If the money is to make up for income you would have earned, it’s taxed as income. If it’s for fixing property or paying for medical bills from a physical injury, that might be treated differently. For lost profits, though, the IRS almost always expects you to treat the award as taxable income.

Let’s look at a practical example. Imagine you own a landscaping business, and a developer blocks your access road for a season, causing you to lose dozens of clients. You sue and win a settlement for the lost revenue. The IRS would expect you to report that settlement as business income for the year you get the payment, just like you would report money earned from mowing lawns and trimming hedges.

Reporting Lost Profits Awards on Your Taxes

If you receive a lost profits award, you need to plan for taxes. The amount you receive should be reported as business income in the year you get it. Here’s how the process usually works:

  1. When you get the award, your lawyer or the payer may send you a Form 1099-MISC showing the amount you received. Even if you don’t get a 1099, you’re still required to report the income.
  2. You’ll include this amount as income on your tax return, usually on your business’s Schedule C if you’re a sole proprietor, or the appropriate line if you have an LLC, partnership, or corporation.
  3. Keep good records of all legal costs. Some of your attorney’s fees and court costs may be deductible as business expenses, which can help lower your taxable income.

Let’s say you received a $40,000 lost profits award and paid $10,000 in legal fees. If the legal fees were paid from the award and are directly related to recovering that business income, you may be able to deduct them as a business expense. This means you’d pay taxes on $30,000 instead of the full $40,000. Make sure you check with a tax professional to see what’s allowed, since deduction rules can get complicated depending on your specific situation.

It’s important to note that you can’t just ignore the tax side of a settlement. The IRS matches up 1099 forms and tax returns, so if you leave this off, it can lead to penalties and interest. Even if you think the payment shouldn’t be taxed, it’s better to report it and get professional advice than to risk an IRS audit later.

Common Mistakes and How to Avoid Them

People often think that because a lost profits award feels like compensation for a loss, it shouldn’t be taxed. But the IRS sees it differently. Here are a few mistakes to watch out for (and how to avoid them):

  1. Not reporting the award at all. The IRS is strict about reporting, especially with settlements. If you get a 1099-MISC or other tax form, the IRS gets one too. Failing to report it is one of the fastest ways to get a tax notice or trigger an audit.
  2. Reporting the award in the wrong year. You must report it in the year you receive the payment, not when the loss happened or the lawsuit started. For example, if you lost profits in 2022 but received the settlement in 2024, you report it on your 2024 tax return.
  3. Forgetting to deduct legal fees where allowed. Some legal costs can help offset the income, so keep careful records and talk to a tax professional about what’s deductible. If you use a tax software or preparer, make sure you mention the legal fees clearly and provide all documentation.