Like it or not, taxes are a part of life. You pay taxes on your income, your social security benefits and the property you own. But what happens when you receive a personal injury settlement – are these funds taxable? According to IRS tax code section 104, the monies you obtain from a personal injury settlement or verdict are generally non-taxable as long as the compensation was for a proven physical injury or physical sickness sustained. In other words, the federal government will not tax any legal recovery that stems from a physical sickness or personal injury, whether you were hurt in a car wreck or injured by a defective product.
However, like most tax statutes and regulations, there are some exceptions that could result in a portion of your settlement being taxed. As such, it’s imperative to discuss these factors with your Southern California personal injury lawyer before litigation begins.
Compensatory damages for physical injuries are not taxable
The purpose of a settlement in a personal injury claim is to provide monetary relief to make the plaintiff “whole” again. These damages can be recovered through an out-of-court settlement or after a trial, and are awarded to reimburse for losses incurred because of a physical injury or ailment. In other words, a personal injury settlement isn’t viewed as a windfall of supplementary cash, but a measure of justice that should be tax exempt.
A judgement or settlement is non-taxable so long as it arose from a physical injury or illness. If your claim alleges emotional trauma, but there is no evidence of actual physical injury, then your legal recovery for emotional anguish or distress would be taxable.
In an alternate scenario, settlement monies for mental anguish or emotional distress may be tax-free if they are directly attributed to a physical sickness or injury. For example, you were in a serious auto accident and were hospitalized for weeks. You required surgery to reset a broken leg and, as a result of your prolonged recovery and inability to enjoy normal activities, you suffered emotionally. In this situation, the damages awarded for mental anguish would likely be non-taxable because it is directly related to your broken leg, which is a medical injury.
In the same vein, you will not be taxed on a personal injury settlement that reimburses you for lost income that results from your physical injury. This includes any past, current and future wages that are lost because of your physical injury or sickness.
Punitive damages are subject to tax
A plaintiff may be awarded compensation that is designed to punish the defendant for wanton or malicious conduct. These are known as punitive damages, and are generally not awarded in personal injury lawsuits.
If you do win any punitive damages, you will have to pay taxes on this amount, regardless if your legal action is based on a physical injury. The silver lining in this rule is that you are allowed to deduct any legal costs that arise from the punitive damage award. A failure to note the punitive damage portion of your settlement on your taxes as “other income” can get you in hot water with the IRS and be construed as tax fraud.
Other exceptions to consider
Plaintiffs should also be wary of “double dipping” when it comes to tax benefits. If you deducted $30,000 on your previous year’s income taxes to account for the money you spent on medical treatment, you are obligated to reimburse Uncle Sam what you have already deducted when you finally receive your personal injury settlement or verdict money.
Any interest earned on your settlement is also subject to federal tax. Believe it or not, this includes investments made with your settlement paycheck.
Questions about the taxability of your settlement?
When you partner with an experienced Los Angeles personal injury lawyer at Salamati Law, we’ll explain how tax liability affects your specific claim and negotiate the most favorable resolution possible. The bottom line is that any compensatory award originating from physical injury is typically not taxable by the IRS.
Personal injury lawyer Sean Salamati is ready to fight for your rights if you have been hurt due to someone else’s negligence. If you or someone you love are considering legal action for a serious personal injury in California, we invite you to call our law offices for a free case evaluation. There are no upfront legal fees to worry about, since you owe us nothing unless we secure damages on your behalf.