Many people who have suffered from a personal injury secure settlements or awards as compensation for their pain and suffering. However, a question that frequently emerges in the aftermath of such settlements is, “Are personal injury settlements taxable?”
This question is particularly important for victims seeking to understand the full implications of their legal victories. In this article, we want to shed light on the subject by discussing the taxability of personal injury settlements.
Understanding Personal Injury Settlements
Typically, personal injury settlements or awards compensate the victim for a variety of losses sustained due to the accident. These losses could include the following, among other damages.
- medical expenses
- loss of income due to inability to work
- pain and suffering
- emotional distress
- loss of companionship
Are Personal Injury Settlements Taxable?
According to the U.S. Internal Revenue Service (IRS), the answer is generally no, but with some exceptions. The overarching rule, as per Section 104 of the Internal Revenue Code, is that any damages received from personal physical injuries or physical sickness are not included in the gross income of the recipient. This means that they are not generally subject to federal income tax.
The keyword here, however, is “physical.” Any settlement funds related to physical injuries or physical sickness are typically tax-free, given that they originate from a personal injury lawsuit or settlement.
Exceptions to the Rule
While the general rule is that personal injury settlements aren’t taxable, there are notable exceptions. Here are some scenarios in which portions of your personal injury settlement could become taxable.
- Interest on Judgments: The IRS does not tax the settlement itself, but it taxes the interest on the settlement. This usually happens when the award payment gets delayed, resulting in interest accruing over time.
- Emotional Distress or Mental Anguish: If your settlement includes compensation for emotional distress or mental anguish not originated from a physical injury or sickness, it’s typically taxable. However, the costs of medical care attributable to emotional distress or mental anguish are not subject to tax.
- Punitive Damages: Even when awarded in a physical injury or physical sickness case, punitive damages are generally taxable. They are intended to punish the wrongdoer, not compensate for a physical injury or physical sickness.
- Lost Wages or Lost Profits: If the settlement compensates for lost wages or lost profits, it could be taxable. The IRS treats this part of the settlement as replacement for what would usually be taxed in a normal income scenario.
- Injury Cases that Didn’t Involve Actual Physical Injury or Physical Sickness: If your case involved harm, but not physical injury or sickness – such as cases related to defamation or invasion of privacy – your settlement could be taxable.
- Pre-existing Deductions: If you took a tax deduction for medical expenses related to the injury or sickness in previous years, and you later receive a settlement for those same expenses, you might need to “pay back” the amount you deducted.
Are Wrongful Death Damages Taxable?
In unfortunate circumstances where negligence or deliberate misconduct results in a death, the deceased’s estate or the surviving family members can file a wrongful death claim to recover compensation. Generally, this type of claim includes damages for medical expenses, lost wages, emotional distress, pain and suffering, and loss of companionship.
Similar to personal injury settlements, these damages are typically not taxable. The underlying reason for this is the same: the compensation is intended to restore the claimant to their original position, or in legal terms, make them “whole” from a wrong that was done to them. The intent is not to provide a windfall but to compensate for actual loss.
However, certain exceptions also apply here. For instance, if the wrongful death settlement includes punitive damages, those are generally taxable. Furthermore, if the estate or family received compensation for the deceased’s lost wages or profits, that portion of the settlement could be subject to taxation, as it would be treated as income that would typically be taxed.
It is noteworthy that handling wrongful death claims can be a complex process due to the intricate nature of the damages and their tax implications. An attorney specializing in wrongful death cases can provide assistance. They can help you navigate the intricacies of these cases, maximize your settlement, and understand your tax obligations when you are compensated for harm.
Remember, every case is unique, and the specifics of your situation could change your tax obligations. Hence, professional advice should always be sought to ensure full understanding and compliance with tax laws.
It’s essential to understand that every case is unique and falls under specific circumstances that can alter its tax implications. This is why consulting with a tax professional is advisable when dealing with personal injury settlements.
Moreover, the structure of your settlement agreement is crucial. A well-drafted settlement agreement can outline which damages are for physical injuries or physical sickness and which items might be taxable. For example, a lump-sum settlement without a clear breakdown of what the various amounts are for can create uncertainty. This potentially opens the door for the IRS to claim more of the settlement is taxable than you believe.
In conclusion, while personal injury settlements are generally not taxable, there are exceptions to the rule. It’s imperative for victims to understand these nuances to have a clear picture of what they will actually receive from a settlement or award. Remember, when in doubt, it’s always best to consult with a tax advisor.