Most personal injury settlements are not taxable. However, there are exceptions. Whether a settlement is taxable or not will depend on the language contained in the settlement or judgment.
Determining if a settlement is taxable or tax-free is more complicated because personal injury settlement agreements generally don’t allocate or identify different portions of the settlement amount to specific damages. There’s no clear distinction between where X amount of the settlement covers lost wages and Y covers physical injuries. The lack of allocation can make it challenging to determine whether a settlement is taxable or not.
If you are wondering whether you must pay taxes on the money you received due to a personal injury settlement, this article will help shed more light on the issue. However, you should always consult a tax professional to ensure that you are fully compliant with your tax obligations.
Is an Out-of-Court Settlement Treated Differently Than a Lawsuit Settlement?
No. Tax laws do not distinguish between out-of-court settlements, lawsuit settlements, or final judgments. The same tax rules apply to any personal injury recovery. In some cases, a lawsuit settlement may help you reduce tax liabilities.
Taxable Personal Injury Settlements
As discussed early, certain portions of a personal injury settlement are taxable. Tax liability most commonly arises as a result of compensation for the following types of damages:
Any portion of a settlement or judgment that provides compensation for punitive damages is considered taxable income by the IRS.
Many settlement agreements do not distinguish how much of the settlement is for punitive damages and how much is for compensatory damages. The punitive damage portion is always taxable. If the settlement does not allocate a specific amount for punitive damages, it is near impossible to determine if any portion of the settlement is taxable.
Any portion of the settlement allocated to compensation for lost wages is considered taxable income by the IRS.
Emotional Distress or Mental Anguish Not Caused by Physical Injury
While emotional distress or mental anguish caused by physical injury is not taxable, the IRS treats emotional distress or mental anguish not caused by physical injury as taxable income. Emotional distress or mental anguish without physical injury generally arises from claims involving harassment, intentional or negligent infliction of emotional distress, invasion of privacy, and defamation.
When there’s a confidentiality clause in a settlement agreement, the recipient should not disclose the settlement terms and details. In some instances, you might be offered a certain amount of money on top of your settlement to keep the settlement terms confidential. The consideration for confidentiality is taxable.
Important Note: The settlement agreement must allocate a specific amount of money as consideration for the confidentiality provision. Suppose a particular amount of money is not clearly identified as the consideration for the confidentiality of the settlement. In that case, a tax court may make its own determination as it did in Amos v. Commissioner. The tax courts determination may be very different than what the parties had contemplated when settling.
Any interest earned as part of a settlement or judgment is taxable by the IRS.
Non-Taxable Personal Injury Settlements
When a settlement is non-taxable, the IRS views the settlement as a payback for the losses, pain, or injury you or your loved one has suffered. In essence, you have gained nothing except receiving compensation for what was taken from you.
So, the settlement amount is not viewed as income and is not subject to tax liability. Settlement monies paid for the following types of damages are not taxable:
Physical Pain and Suffering
Any portion of a personal injury settlement that is paid for physical pain and suffering is not subject to tax liability. For example, compensation for lower back or neck pain caused by a car accident is not subject to tax liability. In other words, the settlement is free and clear from any taxes.
Any portion of a personal injury settlement paid for past or future medical expenses are not subject to tax liability. However, the IRS has made it clear that you must pay taxes on any portion of the settlement covering medical expenses you previously incurred and deducted in any prior year(s). If you have received deductions, you must include the portion of the settlement that covered the medical expenses you received a deduction for in your income.
Example: Assume that you spent $1,200.00 paying medical bills after suffering injuries after slipping and falling on the floor and that you deducted the $1,200.00 from your gross taxable income. If you reach a settlement the following year that allocates $2,000.00 for medical expenses, you will need to pay taxes on $1,200.00 of the $2,000.00 medical expense award.
Emotional Distress and Mental Anguish Caused by Physical Injuries
Any portion of a personal injury settlement that compensates for emotional distress or mental anguish caused by physical injury or illness is not taxable.
How Much Will You Be Taxed?
There is no uniform taxable amount on a personal injury settlement. It all comes down to the type of settlement. As taxable settlements are classified as income, it will also depend on the tax bracket you fall into once the settlement is added to your gross income. The best way to ensure you do not incur any more tax liability than you are legally required to pay is to seek a tax-savvy settlement.
If you or a loved one have questions regarding a personal injury settlement, the attorneys at Prosper Shaked Accident Injury Attorneys PA are here to help.