It is the middle of tax season yet again. If you recently had a personal injury claim that ended in a settlement, then you’re probably wondering if the Internal Revenue Service (IRS) has any claim over your winnings. Are personal injury settlements taxable? No, not in most situations.
For the most part, personal injury settlements and awards are not taxed at the state and federal levels. The reason that they are not taxed is that you did not earn that money as a form of income and for your labor. Instead, you earned it by filing a claim against someone who hurt you, which can hardly be argued as a form of work. In the IRS’s words, assets can be taxed, not liabilities, and personal injury settlements are a liability because they are mostly repaying the money you have already lost.
Is Money From A Personal Injury Settlement Taxable?
Unfortunately, every tax rule has its exceptions, so there are some rare cases in which a personal injury settlement can be taxed by the IRS.
Four of the most common situations in which the IRS taxes a personal injury settlement are:
- Punitive damages: Courts will sometimes allow a personal injury plaintiff to receive punitive damages from the defendant. Punitive damages are used to further punish the defendant for egregious or criminal wrongdoing, not to pay an incurred damage. Because punitive damages are not tied to a loss, the IRS almost always counts them as taxable income.
- Lost wages: Another form of taxable income related to a personal injury settlement is any award you get related to the wages that you lost due to your injury. For example, if you missed a year of work because you were injured and then got a year’s worth of wages in your settlement, then that portion of the settlement can be taxed. It is actually a bit difficult to argue with the IRS on this one because lost wage damages are directly related to your regular income.
- Interest earned: In some settlement agreements, the claimant agrees to be paid their owed compensation across several years, which gives the defendant more time to get their finances in order. The caveat is often that the claimant is owed interest on the amount unpaid as time goes on, almost as if the settlement award was a loan. Any interest you earn on your settlement award can be taxed by the IRS, but the original settlement amount owed to you will not be taxed still. For example, if you get $200,000 in a settlement and earn another $10,000 in interest across the year, then the IRS would tax that $10,000 but not the $200,000.
- Unique non-economic damages: The IRS can also tax certain forms of non-economic damages that are not related to an injury. For example, if you get compensation for your emotional distress that you suffered due to the entire legal process surrounding your case, but not related to the physical injury that started the case, then the IRS can tax that portion of your settlement.
What Are Types of Non-Taxable Settlements?
The personal injury umbrella includes many types of cases that are generally not taxable. Below is a sampling of these cases:
- Attacks and bites by dogs
- Accidents involving motor vehicles and property damage, not injuries
- Litigations resulting from physical illness or sickness
- Injuries resulting from property or building neglect. (For example, a slipping accident caused by an icy walkway.)
- Construction and workplace injuries
- A car that has a dangerous defect is a product liability
- A medication that causes serious harm due to a side effect
- Deaths caused by negligence
Are Wrongful Death Claims Taxable?
Family members can file wrongful death lawsuits on behalf of their deceased loved ones when a wrongful act, neglect, or defect led to the death. Depending on the circumstances, the court may compensate families for financial loss, pain and suffering endured before death, medical costs, funeral expenses, and loss of future inheritance.
Compensation damages are not taxable to the surviving family members, however punitive damages are usually taxable.
Reducing What the IRS Can Tax
A skilled personal injury attorney might be able to negotiate a settlement payment plan that reduces the total amount of money taxable by the IRS. Splitting payments or rearranging the amounts given for certain reasons can reduce the tax impact on your settlement. This is yet another reason why it is so important to develop your case with an experienced lawyer from the beginning.