What Settlements are NOT Taxable?

As a general rule of thumb, most personal injury settlements and jury verdicts obtained from any lawsuit are not taxed by the Internal Revenue Service (IRS). This rule applies only to compensatory damages you receive as restitution for the expenses you incurred in relation to physical injuries or illness. You do not need to include the settlement proceeds in your income for physical injuries or illness ONLY IF you did not take an itemized deduction for these medical expenses on your taxes in previous years. The same rule goes for emotional distress or mental anguish settlements as they too fall under the umbrella of compensatory damages, but only when they are in relation to the physical injury or illness.

The IRS does not tax these settlements or verdicts because they are seen as a way to make the victim whole again after suffering extreme loss.

• Insurance companies and juries use the expenses you incurred for medical bills and the amount of your lost wages to help determine the amount they will pay in settlement or award in court. This is intended to “make one whole.”
• In making you pay taxes on amounts you are reimbursed for medical expenses that you have deducted from income in a prior tax year, the IRS reasons it would not be right for you to keep the full amount of your settlement or verdict since this tax break helped you pay back some of the medical expenses you incurred.
• Therefore, if you did receive a tax deduction, the part of your settlement or verdict that was previously deducted would have to become part of “Other Income” on Form 1040 while doing your taxes.

It would be wise to get a professional tax preparer to assist you with your taxes in a year in which you receive a payout of some kind for your injury claim.

What Settlements are Taxable?

Punitive Damages

There are many exceptions given by the IRS to the general rule stated above. Punitive damages received during your lawsuit are subject to taxation rules by the IRS.

Even if the punitive damages were received in your lawsuit for personal physical injuries or illness they must still be reported as “Other Income” on Form 1040.

The IRS claims that punitive damages are given to deter other individuals from acting in the same manner as the defendant of your case — a form of punishment for the defendant for their reckless and wanton behavior (which is required in order for a jury to award such damages in the first place). These are not damages that are equated to an expense you incurred as a result of the accident, which is why they must be reported when filing your taxes.

Exception: There is one way punitive damages are not taxable and that is when they come from a wrongful death lawsuit. In these cases, refer to IRC Section 104(c) which allows the exclusion of punitive damages from your income.

Employment Lawsuits

If you received a settlement in an employment-related lawsuit for lost wages (i.e. severance pay, back pay, front pay) then these are considered taxable wages and are subject to employment tax withholding by the payor. These should be reported by you as ‘Wages, salaries, tips, etc.” on line 1 of Form 1040.

Interest Accrued on Settlement/Award

Another exception to the general rule is if your settlement or jury award accrues interest while waiting to be paid. One example of this occurring is a jury awarding you a certain amount but the defendant files an appeal — interest accrues while the appeal is pending and if you win and get paid, that interest is taxable as “Interest Income.” This interest is not intended to make you whole, nor does it go back to any exact expenses you incurred, which means the IRS considers it taxable income and it must be reported.

Only Emotional Distress or Mental Anguish

As of 2017 in the passing of the Tax Cuts and Jobs Act, if your settlement or verdict is based solely on a claim of emotional distress that is not otherwise related to a physical injury or illness, then it is considered taxable income:

“The amount you must include is reduced by:

• amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted and
• previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.”

Taxes can be complicated enough without having to consider money received in a settlement or verdict arising out of an injury claim. Even before you decide to settle your claim or go to trial you should first consult a qualified tax expert to be properly advised as to what taxes you may have to pay on such money, so that you can fully understand the total amount you may receive after not only deducting the attorney’s fees and expenses and possibly medical liens, but also how much you may lose to the government (state and federal) in taxes.

Hartsoe & Associates has represented Winston Salem, Greensboro and High Point clients who have been seriously injured in automobile accidents, truck accidents, industrial accidents, product liability cases, or in other scenarios for many years and has the experience and toughness to obtain the best result possible in your case, but to also guide you in the finer points of these cases. Please call 336-725-1985 or fill out our contact form to schedule a consultation.