If your attorney secures a settlement at the end of a successful personal injury claim, then you’ll certainly be excited for the opportunity to move toward financial stability again after your accident. However, before you start making plans with the financial compensation achieved through the settlement, you should be aware that the Internal Revenue Service (IRS)—everyone’s “favorite” government agency—might expect some of it as taxable income. Whether the IRS considers your settlement taxable depends on a variety of factors with a focus on the reasons why you were compensated, so every settlement is unique.
Compensation for Physical Injuries
The IRS does not consider a settlement as taxable income if it was received for physical injuries or illnesses, and the recipient did not take an itemized deduction for related medical expenses.
If you did take a medical expense deduction in previous tax years and you are compensated for those medical expenses through the settlement, then you will have to include that portion of the settlement as income in your next tax filing. You may need to allocate medical expense proceeds on a pro rata basis depending on if you paid those medical expenses across multiple years, too. Generally, any taxable settlement portion for medical expense reasons must be reported as “Other Income” on Form 1040, Schedule 1, Line 8z.
Compensation for Emotional or Mental Injuries
Settlement proceeds for emotional or mental injuries—which can be outlined as non-economic damages—follow the same taxable/nontaxable rules as described above for physical injuries. However, if the non-economic damages are not related to a physical injury or illness that you suffered, then that portion of the settlement must be reported as taxable income. For example, if you were a successful plaintiff in a libel claim filed in civil court, then mental injury (non-economic) damages won in that case would likely be taxable. Most people who enter civil court do so to file a personal injury claim involving physical injuries, though, so this is uncommon.
Furthermore, if you are required to report emotional or mental injury damages as taxable income, then the amount that you report can be reduced by two factors:
- Any amount related to medical expenses deemed necessary to treat your mental or emotional anguish, e.g., therapy or psychological care.
- Any amount for medical care related to your mental health that had already been deducted and did not provide a tax benefit.
Compensation for Lost Income
If you receive compensation in a personal injury claim to replace your lost income or wages, then it might be an amount that reflects what you would have been paid after taxes. For this reason, settlement portions for lost wages might not be taxed by the IRS because the money was already taxed when the defendant or payor first received the money. Additionally, in your itemized settlement, it is possible that compensation for lost income is bundled with compensation for physical injuries. If this is the case, then the IRS taxability rules for physical injury compensation could apply instead.
However, if you filed an employment-related lawsuit that resulted in a settlement to repay lost income, wages, or profits, then the IRS will consider those payments as taxable income. For example, unlawful discrimination settlements would generally be taxable.
Compensation for Lost Property Value
Compensation paid through a settlement for lost property value is not taxable if the compensation is less than the “adjusted basis of the property.” For example, if your car was totaled and valuated at $10,000 but you were compensated just $5,000 for it, then that $5,000 portion of the settlement would not be taxable. Keep in mind that if you have any reason to otherwise report the damages or lost property in your tax return, then you must adjust its value to its original value minus the compensation you received.
If you are compensated for lost property and the compensation amount is greater than the “adjusted basis,” then it can be taxed. It is not common for this circumstance to occur, though, because defendants in injury claims are careful to never pay more than a fair value for a loss.
Compensation to Punish the Defendant
In rare cases, a court might approve punitive damages, which are used not to compensate the claimant for a loss but instead to punish the defendant for egregious wrongdoing. If you are paid punitive damages through a court award, then you might consider yourself lucky. Yet you might also feel a little unlucky when you learn that all punitive damage payments are considered taxable income by the IRS, even when those damages are awarded at the end of a physical injury claim.
For Any Questions, Talk to Attorneys
Figuring out if your settlement or award can be taxed can be a complicated process. It is highly recommended that you talk with your personal injury lawyer and a tax attorney about what to expect. There are always wrinkles that can change how the IRS views portions of your settlement, for better or worse. With legal professionals leading the way, you shouldn’t be surprised by whatever tax implications reach your settlement.
Geoff Meyerkord Law Firm, LC offers comprehensive and experienced personal injury claim and trial representation in Illinois and Missouri. We are always honest and transparent with our clients, so you won’t feel left in the dark about what compensation might be pursuable based on the specifics of your claim or lawsuit. Call (314) 500-6000 if you need help with a case.