If you receive a personal injury compensation payment, you may not have to pay tax on it.
The purpose of a personal injury settlement is to compensate you for your losses. In most cases, there are no taxes owed on personal injury settlements as the Internal Revenue Service (IRS) does not consider this type of income to be a wage or salary. However, there are important exceptions.
Because the law cannot undo your injuries, the only thing it can do is provide a legal means for you to receive compensation from the party who caused the accident that resulted in your injuries. The compensation is viewed as recouping losses sustained as a result of another person’s negligent acts. It would not make sense to tax a personal injury settlement because it is not windfall, income, or earnings.
Therefore, most personal injury settlements are non-taxable. However, there are always exceptions to the rule.
Compensation for Physical Injury and Illness
Regarding personal injury settlements, the Internal Revenue Service states:
“If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income.” (from IRS Publication 4345, Rev. 4-2015)
There are exceptions as to when personal injury compensation is taxable. For your settlement to be non-taxable, the compensation must relate to a specific physical injury or physical illness. However, if you deducted medical expenses related to the injury on your tax returns and the deduction provided a tax benefit, that amount of your settlement will be subject to taxes.
The IRS deems that it is unfair for you to have received a tax deduction for medical expenses that were paid off by money from your settlement. Additionally, whether you receive wages from your employer or those wages are included as part of a settlement award, you are required to pay income taxes on that portion.
Lost Wages and Income
Compensation for lost wages and income in a personal injury settlement is taxable. This portion of your settlement is intended to reimburse you for income you lost due to the accident. If the accident had not occurred, you would have earned the income and paid taxes. Therefore, you must pay the taxes due on that amount. Speak to your attorney about whether a part of your verdict or settlement is earmarked as lost wage compensation.
Punitive Damages
Punitive damages are a special type of damages that is only paid in certain personal injury cases. They are intended to “punish” or the defendant for grossly negligent acts while further financially rewarding the claimant. Punitive damages that may be included in a personal injury settlement are always taxable.
Mental Anguish and Emotional Distress
Many personal injury settlements include an amount to compensate for mental anguish and emotional distress. It is not customary for the IRS to tax this amount if the mental anguish and emotional distress is directly related from the physical injury and/or sickness. If not, you need to include the amount in your taxable income, though you may be entitled to certain deductions from the gross amount.
Compensation Paid in exchange for confidentiality
If you received compensation for agreeing to keep the settlement confidential, that amount may be taxable income.
Work with Your Personal Injury Lawyer
The above information is a brief summary of the intricacies of taxable personal injury settlements. It is always best to discuss tax matters with a professional tax adviser and your attorney. We work with our clients and their tax advisers to minimize the tax liability for personal injury settlements.