Tax Implications of Personal Injury Settlements

The author of this blog post is Jim Ingolia, a NYC Personal Injury Lawyer who helps victims of personal injuries get the settlements they deserve. 

Generally speaking, personal injury settlements and awards are considered tax-free income, meaning you don’t have to pay the IRS a dime out of your winnings. The money awarded to you through either an official judgment or a well-negotiated settlement will be yours to split with your attorney. Note, however, that this view of the tax law takes only specific forms of compensation into account. Bodily injuries, quantifiable pain and suffering as the result of said injuries, medical bill awards, and lost wages directly attributable to physical injury are seen as offsetting a loss and are therefore not touched by the government. As you might have guessed, though, that’s not the end of the story.

Jurisdictional Variations
In addition to the federal government’s role in collecting taxes, each state also has their own tax laws. Some of these may differ substantially from the national IRS, so it pays to speak with a tax expert before signing on to a settlement. The federal tax code is thankfully straightforward on the matter of personal injury settlements, but some states may have obscure and difficult-to-understand laws regarding taxation. 

Exceptions to the Rule
Punitive damages are regarded as taxable income. These awards are intended to punish the person or company with a monetary “fine” which then goes to the plaintiff. If you’ve received punitive damages as part of your compensation package, the sum must be added to the gross income calculation on that year’s tax return forms. 

It is also worth noting that any interest you accrue through investments made with your personal injury settlement are fully taxable under the federal code. The only exceptions are special trusts or accounts which defer taxation to a later time, but these exceptions are not unique to lawsuit settlements. 

Case Specific Settlements
Some attorneys take taxation into account when negotiating a settlement and for good reason. How you settle a case can have a bearing on how much of the award must be handed over to the IRS. For instance, if you negotiate a settlement agreement that states all money is intended for visible physical injuries, the money will be nontaxable. If the award comes from a judge or jury, however, the amount may be itemized in a way that puts more of it up for grabs. The IRS isn’t necessarily beholden to a legal agreement’s specific wording, but it will hold up in most instances.

Important Things To Note
The federal government’s tax code can be tricky for even a lawyer versed in the field, so don’t be surprised when there are exceptions upon exceptions that obscure the law. Here are some of the most important things to note:

  • If you have already claimed a medical expense deduction on your tax returns, the IRS expects you to make up that difference with any future personal injury award.
  • Cases which involve no physical injury such as libel, employment-related settlements, wrongful termination, and discrimination may result in settlements that are taxable under the current law.
  • Though punitive damages are usually taxable, they too fall under tax-exempt status when awarded in wrongful death cases.


A Final Word
Though there are exceptions as noted above, personal injury settlements fall largely into tax-exempt status. Why is this important? Because too many people throw away their chance to sue for damages based on the erroneous notion that most of their award will go to the IRS. Nine times out of ten, this simply isn’t the case. If you have a legitimate personal injury case, talk to a good lawyer in your area, speak to a tax professional if necessary, and get the compensation you deserve for your injuries.

Sources
http://www.hhcpa.com/blogs/income-tax-accountants-cpa/when-are-legal-settlements-taxable
http://www.marketwatch.com/story/taxes-on-personal-injury-awards-and-settlements-2013-06-03
http://www.yourlawyer.com/blog/do-i-have-to-pay-taxes-on-my-personal-injury-settlement/
http://taxation.lawyers.com/tax-consequences-of-a-legal-settlement.html
http://www.forbes.com/sites/robertwood/2011/11/16/dont-fail-to-consider-taxes-when-settling-litigation/
http://thelawdictionary.org/article/what-is-taxable-in-a-personal-injury-settlement-under-the-u-s-tax-code/