Many personal injury cases settle prior to trial, as you may have heard. The case is closed when you accept the settlement offer of the insurance company (or defense attorney) and sign a release.
What happens next? You get your money fast (minus the attorney’s contingency fee) and can go back to living your normal life. Uncle Sam might be eligible for a portion of your settlement. Let’s take a look at some income tax issues that may apply to personal injury settlements.
The compensation for physical injury is not taxable
The proceeds of most personal injury cases are generally not subject to federal or state tax. It doesn’t matter if the case was settled before or after you filed a personal injury lawsuit in court. It doesn’t matter whether you won a verdict at trial. The verdict or settlement proceeds of most personal injury cases are not subject to taxation by either the federal government (the IRS) nor the state. For example, damages received due to personal physical injuries or sickness are not exempted from federal tax law.
This means that typical personal injury damages, which are intended to compensate claimants for things such as lost wages, medical bills and emotional distress, as well as loss of consortium and attorney fees, are not taxable, so long as they are derived from a personal injury, or a physical illness. A claim for a physical illness is one that involves a claim for an injury. Any damages you receive as a result, such as those caused by a germ being accidentally exposed, are not taxable.
Exceptions to the General Rule
Even if you sustain a physical injury or sickness, you will be subject to taxation on damages related to a contract breach if that is what caused your injury and is the basis for your lawsuit.
Punitive damages always become taxable. Your lawyer will ask the judge or jury to seperate punitive and compensatory damages if you have a punitive damage claim. This allows you to prove to the IRS that a portion of your verdict was for compensatory damage, which are not taxable. Learn more about the types of damages that can be awarded in personal injury cases.
Only Emotional Injury Claims
The settlement or verdict you receive is not taxable if it was based on a physical injury. Your settlement or verdict, unless you can prove the least amount of physical injury, would be taxable in the event that you have a claim for emotional distress, employment discrimination or other forms of harassment.
As much of your settlement as possible is not subject to tax
Sometimes, you may have two claims against the defendant. One of these claims could relate to personal injury while the other does not. If the personal injury claim is more than the non personal injury claim, it’s important to clearly state in the settlement agreement which amount of the settlement will be paid for the personal injury claim.
The IRS can always challenge the taxability of a settlement. However, this is the best way to ensure that most of your settlement is exempt from tax.