Is my Personal Injury Settlement Taxable?
Many personal injury cases are settled before or during a trial and only a small percentage are ever tried to the point of a verdict. In saying this, it’s important to know that the case is completely settled the moment your lawyer informs the defense attorney that you accept their settlement, which can be as easy as an email or phone conversation.
Many times, these types of settlements will leave you with questions in terms of whether or not the money you receive from a personal injury lawsuit or claim is taxable. The truth is, personal injury settlements can be nontaxable, taxable, or even partially taxable depending upon the certain circumstances of the case and the kind of injuries that were suffered.
What this article aims to do is give you more information about the general rules that apply to non-taxable personal injury settlements and the exceptions to these rules in which personal injury damages are taxable. The information in this article can be crucial for those who are planning out a meeting with their tax advisor so they can ask the right questions while preparing for tax season.
Be sure to check out our Ultimate list of personal injury questions for even more answers to all of your questions.
Taxation and Personal Injury Settlements
For the most part, personal injury settlements are not taxable by state or federal laws, however there are quite a few exceptions that can make at least some portion of your settlement award taxable. The IRS doesn’t consider the money that people receive in personal injury claims as wages or salaries, but they do consider this kind of income as compensatory. Most people view compensatory as meaning nontaxable, but this isn’t 100 percent correct, which can potentially leave people owing a lot of money if they aren’t too careful.
Physical Injuries and Sicknesses
The money someone receives in a personal injury settlement that directly correlates to a physical injury or sickness is generally non-taxable. This means things like medical bills, pain and suffering, emotional distress and attorney fees are not taxable if they are connected to a personal injury or physical sickness. A physical sickness technically is a claim for an illness that you were negligently exposed to.
The main reason why these types of settlements are non-taxable is because they are compensatory and are primarily a reimbursement for out-of-pocket losses.
Vehicle and Property Damage
This kind of compensation is not taxable, and it includes the costs for repairs as well as a reimbursement for any money spent on a rental car while your car was in the shop.
There are several exceptions to the general rule which applies to physical injuries or sicknesses, and one of the main exceptions is no double dipping. What this applies to, is the situation in which someone gets a tax benefit in the past that’s connected to a specific personal injury case and then tries to take advantage of additional benefits once the case is settled. If you decide to deduct some of your out-of-pocket costs for a personal injury, you’ll have to more than likely use the rewards you receive from your settlement to pay back the IRS for what you previously deducted.
Interest is another exception to these general rules. If you ended up earning interest in a personal injury case, that money isn’t tax-exempt and is considered interest income on a 1040 form.
When any kind of mental anguish or emotional distress does not have a direct relation to a physical injury or sickness, then that money is taxable. Some other taxable examples of personal injury settlements that are non-physical injuries include things like harassment, wrongful termination, invasion of privacy and discrimination.
Punitive damages refer to the money that is awarded to an injured person that goes beyond any kind of ordinary compensation and is intended to punish the defendant or wrongdoer. This kind of monetary award is almost always taxable even if it is directly connected to physical injuries or sicknesses. If your case does involve punitive damages, then your lawyer will ensure that the judge separates the settlement money into compensatory and punitive damages so you can prove to the IRS that part of the verdict was tax-exempt.
When it comes to compensation for lost income, you’ll generally be subject to income tax when dealing with personal injury settlements, even if lost wages were due to a physical injury or sickness. The reasoning behind this exception is that if you weren’t injured then your original income would have been taxed, so the compensation that is intended to replace the lost income is rightfully taxable like it would have been.
It Can Get More Confusing…
Although this article has given you a more than adequate amount of information about how taxes can affect any kind of personal injury settlement, there are still several other exceptions to just about every legal and tax-related rule given by the IRS. By conferring with an experienced personal injury lawyer you’ll more easily maneuver your settlement around these exceptions and get the very most non-taxable settlement compensation as possible within your given circumstances. If you have any questions regarding your personal injury case, please contact us!