“Only Two Things in Life are Certain” – Do I Have to Pay Taxes on My Personal Injury Settlement?
While the answer to this question may be governed by a general rule, notable exceptions to this rule exist. Knowing them will help maximize the amount of non-taxable damages awarded in a settlement.
The Most Likely and Most Desirable Outcome
Whatever the exact percentage might be, if you have a personal injury claim against a person or an organization, the chances are high that your case will never land on the docket. This is good news for anyone who decides to file a personal injury claim since the alternative involves periodic visits to the courtroom over a span of many months or even years, and entails a considerable investment of time and money – valuable resources which those recuperating from an injury would prefer not to waste. A skilled personal injury attorney will usually aim to resolve the case without a trial as long as a fair settlement is reached.
A satisfactory settlement is one that covers both material and non-material losses suffered by the injured party. These losses may include the cost of healthcare, lost wages, pain and suffering and emotional distress related to the injury. In any case, with the help of an experienced lawyer, at the end of the legal proceedings, the injured party should be paid out a sum of money that sufficiently covers and compensates for the damage they sustained. Having received all this money, a person may wonder: “Is my personal injury settlement taxable?” In this week’s blog post, we explore the answers.
The General Rule
The general rule is that personal injury settlements are not subject to taxes. Neither federal nor state laws impose tax obligations on money paid out to injured parties in a personal injury case. This general rule applies both to money obtained as a result of settlements or awarded to plaintiffs in court verdicts. The Internal Revenue Service (IRS) considers this kind of income compensatory and therefore exempts it from income tax. According to federal tax law, damages received as compensation for physical injury or physical sickness are excluded from the taxpayer’s gross income. Similarly, money paid out as compensation for vehicle or property damage is likewise not taxable. This kind of compensation may include the cost of repairs or reimbursement for a replacement vehicle.
However, does the general rule mentioned above mean that all money received by the plaintiff in a settlement or through a jury verdict is exempt from taxes? Not necessarily. There are important exceptions to the rule. First, if a person claiming personal injury has already deducted some of the material losses as a tax benefit in the past, the IRS may demand the deduction be repaid from the money awarded. This may be related to situations where the injured party pays for some of the costs associated with the injury, such as medical bills, out of their own pocket. Second, any part of the sum received in compensation is tax exempt only as long as it is related to the physical injury or sickness. Money awarded in compensation of emotional distress or mental anguish will only be exempt from taxes if it can be shown that these conditions are experienced as a direct or indirect result of physical damage the plaintiff has sustained.
What does this mean for the recipient of compensation? If a personal injury claim is based on accusations of harassment, breach of contract, wrongful termination, discrimination, or any other fault whose negative consequences are not physical, the money obtained in compensation is subject to taxes.
Third, punitive damages are taxable. Punitive damages are usually awarded as a part of a court verdict rather than a settlement with the purpose to punish the defendant for especially egregious conduct.
They are often paid out if a judge or a jury deems compensatory damages to be an insufficient measure to serve justice to the plaintiff. Even though punitive damages usually are related to physical injury or sickness, they are subject to taxes. That’s why in a verdict, punitive damages are stated separately from compensatory damages. This makes it easier for the plaintiff to prove to the IRS which part of the verdict was tax-exempt.
Interest on the Verdict
Fourth, there is an exception to the rule when a judgment includes interest on the money awarded. In most states, courts add interest to the amount mentioned in the verdict for the time the case was pending (pre-judgment interest) and for the time that passes until the money is actually paid out (post-judgement interest). In Rhode Island, both types of interest are set at a rate of 12% per annum. This interest is taxable.
Lost Wages or Loss of Income
The last exception is money awarded as compensation for lost wages or loss of income. Even though normally related to physical injury or sickness, these damages are taxable. The IRS treats this part of compensation as a replacement for income that would have been paid and as that income would have been taxed – so are the damages.
It is important to remember that, as Benjamin Franklin once said, “in this world, nothing can be said to be certain, except death and taxes.” Even though money received in damages for personal injury is exempt from taxes, the IRS still may challenge the tax-exempt status of a settlement. That’s why it is so important to be able to count on the skills and experience of an experienced personal injury attorney who can ensure that a personal injury claim is drafted in a way that maximizes tax-exempt damages for their client.