Tax ramifications are considered when deciding whether to settle or go to trial on a personal injury claim. Personal injury settlements and damages are often comprised of tax-free compensatory damages for bodily harm or disease.
Certain damages and settlement awards, however, are not tax-free. The amount of tax that a plaintiff must pay is determined by how the proceeds are classified.
Settlements provide the parties more influence over the characterization of proceeds since they allow them to negotiate distributions. If the case goes to trial, the judge or jury will decide how the proceedings will be characterized.
Physical Injury or Illness Damages and Settlement Awards
In general, neither the federal government nor state taxing authorities tax the proceeds of personal injury or physical disease. Medical expense awards are also non-taxable, unless the plaintiff claimed an itemized deduction for medical expenses in a previous year.
Emotional Distress Damages and Settlement Awards
If the emotional anguish was caused by a physical accident or sickness, the compensation may be non-taxable.
For example, if the litigant was injured in a vehicle accident and endured mental distress while recovering, the emotional distress compensation would be non-taxable. It would be taxed if a physical injury or disease did not cause the emotional suffering. The same rules apply to medical expense deductions.
Lost Wages or Profits?
Compensation for missed salaries or business profits is normally taxable as taxable income compensation. On the other hand, compensation for lost wages or company profits is not taxable in personal injury cases.
To qualify for non-tax treatment, the lost wages or business profits must be due to a physical injury or disease.
Property Value Decline
It is not taxable if damages or a settlement award compensate for a reduction in property value. For example, compensation for a damaged automobile would not have to be reported to the IRS. The excess is reportable income if the property settlement exceeds the adjusted basis (the purchase price after tax modifications).
Interest on the judgment is another taxable component of a personal injury verdict. Most states have court rules that add interest to the verdict based on how long the case was pending.
For example, if you filed your complaint on January 1, 2019, you would normally be entitled to interest on the verdict beginning on January 1, 2019, and continuing until payment is received.
If you won at trial on January 10, 2020, but the defendant appeals and does not pay you until March 31, 2021, you would be entitled to two years and three months of interest on the unpaid award. This is taxable interest.
To summarize, if a component of a settlement or award is for interest, it is taxable as “interest income.” It should be noted that many state courts would add interest to award amounts for the time the case was pending.
Punitive damages are normally considered taxable income even if awarded to compensate for bodily pain or disease. Punitive damages are sums given to the opposing party to punish them for misbehavior. If punitive damages are awarded at trial, the attorney will request that the amount be divided between compensatory and punitive damages.
Is it Possible to Deduct Attorney Fees in Personal Injury Cases?
Attorney fees are taxable, although they can be deducted from the taxable component of the revenues. Assume the plaintiff was granted $200,000 in total, with $100,000 in compensatory and $100,000 in punitive damages, and the attorney’s fee was 40% of the total. Because punitive damages are taxable, the claimant may only deduct $40,000 from the amount granted.
Attorney fees are likewise classified as miscellaneous itemized deductions and cannot be deducted if the standard deduction is used. Itemizing deductions is only advantageous if the taxpayer’s total deductions exceed the standard deduction. A litigant should only deduct attorney fees if the total of their deductible items exceeds the standard deduction.
Can a Personal Injury Settlement Raise Your Tax Rate?
Another factor to consider when defining settlement payments is tax rates. Punitive damages and interest, for example, are taxed as regular income. This implies that the award is added to the litigant’s other regular income, such as wages, and may push them into a higher tax bracket, increasing their tax rate.
What Are the Different Types of Non-Taxable Settlements?
Many types of litigation fall under the umbrella of personal injury and are often not taxed.
A selection of these cases is shown below:
- Dog attacks and bites
- Vehicle collisions and property damage, but no injuries
- Physical ailment or sickness-related lawsuits
- Injuries caused by property or building neglect. (For instance, a slipping mishap on an icy walkway)
- Construction and workplace accidents
- A car with a dangerous flaw (product liability)
- A drug that, as a result of a side effect, causes substantial harm
- Deaths as a result of carelessness
Is Wrongful Death Compensation Taxable?
When an unlawful act, neglect, or flaw caused the death, family members can pursue wrongful death claims on behalf of their deceased loved ones. Depending on the circumstances, the court may pay families for financial loss, pain and suffering incurred before death, medical expenditures, funeral expenses, and loss of future inheritance.
Compensation damages are not taxable to surviving family members, whereas punitive damages are.
Only Emotional Injury Claims
Remember that the settlement or verdict is only non-taxable if it is the result of physical harm. Suppose you have a claim for emotional distress or employment discrimination but no actual physical injury. In that case, your settlement or verdict will be taxable unless you can prove even a minor amount of physical injury.
Limiting the IRS’s Taxable Income
Ascertain that as much of your settlement as possible is tax-free.
You may have two claims against the defendant, one of which involves personal injury and the other does not. In this scenario, especially if the personal injury claim is significantly larger than the non-personal injury claim, you should specify in the settlement agreement what portion of the settlement belongs to the personal injury claim and what portion relates to the non-personal injury claim.
While the IRS can always challenge a settlement’s non-taxability, dividing your payout in this manner provides you the best chance of having the majority of the settlement exempt from taxation.
A qualified personal injury lawyer may be able to negotiate a settlement payment plan that decreases the total amount of money that the IRS will tax. Splitting payments or altering the amounts supplied for specific reasons can help you save money on taxes. This is another reason why working with an expert lawyer from the start of your case is critical.
Should I Consult a Personal Injury Attorney?
Settlement negotiations provide the tax-conscious litigant more power over the classification of proceeds. Consulting with a personal injury attorney may help you maximize your tax consequences if you have filed a personal injury claim.
You do not want to find yourself in trouble with the IRS, especially after you’re recovering from a personal injury. Use LegalMatch to find a qualified lawyer who can walk you through the tax implications of a new personal injury settlement. You’ll save yourself a headache and a potential run-in with the IRS.