Seeing the end of a personal injury case, especially when there is a sizeable settlement involved is usually very good news. You may feel like the stress of the case just melts away and you can breathe again. If you had an attorney handle your case, he or she may have maximized our compensation. Your bills get paid and you have been well compensated for the injuries and property loss you sustained. Justice has been served and it feels good.
The tax time rolls around and you begin wondering if you actually owe taxes on the money you received from that personal injury case. Is it actually income and thus subject to income tax? Are you required to report it?
Tax Laws and Your Personal Injury Settlement
Prior to 1996, the majority of personal injury settlements were tax free. It didn’t’ matter if they were for physical injuries or emotional ones, they were not taxed. Tax laws have changed though and while physical injuries settlements are non-taxable for the most part, there are some exceptions.
The Internal Revenue Service (IRS) does not define the money that you are awarded for a personal injury claim or lawsuit as wages, salaries or tips. Instead, it is considered to be “compensatory” money meaning that it is money intended to compensate you for a loss. While most people believe that income deemed compensatory is automatically non-taxable, this is not entirely accurate according to IRS rules. There are some instances where that settlement income could be taxed and failure to properly identify your income and file your taxes accordingly could result in you taking a significant financial hit.
What Portion of a Personal Injury Settlement is Not Taxable?
The IRS has provided detailed information regarding what can and cannot be taxed in regard to a personal injury settlement or jury award. The money from these cases is specifically excluded from being any type of taxable income when it is intended to compensate you for:
- Physical injuries
- Lost wages that are a result of your physical injuries
- Emotional distress that is caused by your physical injuries
This means that money that falls under the category of lost income, medical bills, and even pain and suffering damages are, for the most part, tax free.
This is not a hard, fast rule, though. There are exceptions.
Exceptions to Non-Taxable Personal Injury Settlements
The decisions you made regarding what you did with the money from your settlement as well as how you filed your taxes in the past can weigh heavily on what you may owe the IRS on your settlement.
For instance, if you already received any type of tax benefit that relates to your case then you are not qualified to take advantage of or receive any additional tax benefits. This can include deducting on a previous year’s income tax return any out of pocket costs you may have paid for your medical care that was related to the accident. While that is perfectly legal and there is absolutely wrong with doing that, you cannot double dip. This means that since you have been compensated for those expenses, you are required to pay back to the IRS what you deducted on that previous return. It is considered “other income” on the 1040 tax for – and it needs to be reported.
Is Interest Earned on a Settlement Taxable?
If you earned interest on your settlement or any money that was recovered from your personal injury case, the interest on the money is not tax-exempt even if the entire settlement is. It should be listed on your 1040 as “other income.” If you aren’t certain whether you should report it or not, talk to your attorney or tax professional.
Are Punitive Damages Taxable?
Punitive damages are not directly related to medical or property damage. The intention of these types of awards is to punish the defendant for reckless or negligent actions. Often, they can be taxed, even when they are associated with physical injuries. They should be reported as “other income” on your 1040 tax form.
If you received a large settlement in punitive damages, you should look into what your tax burden will be well before tax season. In some cases, you find that the amount you owe is high enough to warrant estimated tax payments all year long.
These are the most common ways that a settlement can be taxable, but there are less conspicuous circumstances that can get you into trouble and leave you with serious tax penalties. Talk to your attorney to find out what all of your tax obligations are and what you need to do to stay out of trouble.
If you have been injured in an accident and are seeking compensation or have received compensation and aren’t sure what, if any, part is taxable, let us help. At the Law Offices of Alan LeVar, our knowledgeable, experienced attorneys will stick with you and help you at every stage of your settlement process, from first filing your taxes to reflect any money you are required to pay taxes on. Personal injury cases can be confusing, and the IRS laws are extremely complex. Don’t try to do it on your own. Let us help.