Will I have to pay taxes on my accident settlement or verdict?
If you have been injured in a bad accident, you probably wonder if you will be able to settle or have to go to trial.
Statistics from the U.S. government indicate that most personal injury cases are settled before the trial starts. Only 4-5% of personal injury cases ever see a courtroom.
Once you accept the settlement offer, the case is over. Your attorney simply needs to inform the defense lawyer that you have accepted the offer by phone, email, letter or email.
But what about taxes?
Now that the case is done and you have your settlement (minus your attorney’s contingency fee), is the money taxable? And is the money taxable for verdicts, if your case did happen to be one of the small percentage that go to court?
These questions stress out many accident victims. Imagine if you have suffered serious physical injuries in a car accident. You are depending upon that money to pay your medical costs and to make up for lost income. What if you had to actually pay taxes on part of that money that you needed? What a nightmare.
Fortunately, that type of scenario does not usually happen in most accident cases.
Compensation for physical injuries is non-taxable
Whether a settlement or judgment is taxed depends entirely on the claim’s origin.
Generally, settlement and verdict proceeds from a personal injury claim are not subject to state or federal income tax, according to Section 104 of the tax code. That is because most personal injury claims involve physical injuries, which the IRS treats as non-taxable.
It is irrelevant whether you settled your personal injury case before or after filing the lawsuit. Nor does it matter if you went to trial and secured a verdict.
Neither the IRS nor any state tax authority can tax you on settlement or verdict compensation for most personal injury cases.
Federal tax law also excludes damages that are received due to personal physical injury or physical sickness from your gross income for tax purposes.
So, most personal injury damages in a settlement or a verdict that compensates you for the following are not taxable at the state or federal level, if they are awarded due to physical injury or a physical sickness:
- Lost wages
- Medical bills
- Emotional pain and distress
- Pain and suffering
- Loss of consortium
- Attorneys’ fees
IRS Publication 4345 says:
Emotional distress or mental anguish
The proceeds you receive for emotional distress or mental anguish originating from a personal physical injury or physical sickness are treated the same as proceeds received for Personal physical injuries or physical sickness above.
If the proceeds you receive for emotional distress or mental anguish do not originate from a personal physical injury or physical sickness, you must include them in your income. However, the amount you must include is reduced by: (1) amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted and (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit...
What are the exceptions?
When it comes to state and federal tax laws, there are exceptions for almost everything.
For example, if you suffered a physical injury or illness, you will pay taxes on any damages that relate to breach of contract – IF that breach caused the injury and the breach is the reason for the lawsuit.
Also, punitive damages, which are intended to punish the legally liable party for reckless conduct, are always taxable at the state and federal level. If you are asking for punitive damages, your attorney should ask the jury or attorney to separate the award into compensatory and punitive damages. This ensures that you can show the IRS that part of your award was for compensatory damages and is non-taxable.
For example, the recent Hulk Hogan lawsuit against Gawker for libel won Hogan a total award of $115 million in damages, plus $25 million in punitive damages. Because this cause did not involve physical injuries, Hogan probably is on the hook for taxes on the entire amount. Even if it were a physical damages case, he still would have to pay taxes on the $25 million in punitive damages.
Another part of a personal injury settlement or verdict that may be taxed is interest on the judgment. Most states have rules that will add interest to the settlement or verdict for how long the case was pending.
Remember, your settlement or verdict is non-taxable only if it is due to a physical injury. If your claim is solely for emotional distress or for being discriminated against at work, the money you receive would be taxable.
How to make sure your settlement or verdict award is non-taxable
Your case could involve two separate claims against the other party. One of them may relate to a personal injury from a car accident, and the other claim relates to a non-physical injury.
In such situations – especially if the personal injury claim is much bigger than the other claim – you should make it very clear in the settlement agreement. One amount of money is for the personal injury claim, and the other amount is for the non-personal injury claim.
Attorney fees and taxes
Forbes’ experts say you should factor in the cost of your lawyer as you are considering taxes. If you are the plaintiff and you used a lawyer that you pay on a contingency basis – he or she gets 1/3 of whatever money you recover, for example – for tax purposes, you are treated as getting 100% of the award, even if you pay 1/3 to your attorney.
If your entire lawsuit is regarding physical injuries, this is not a problem. However, if any part of your settlement or verdict is taxable, beware!
For example, if you sued someone for your car accident injuries for $100,000 and half of that was for emotional distress, your attorney might keep $33,000. You think you have to claim only $17,000 of that as income.
No. You would have $50,000 of income for federal tax purposes.
The bottom line on this complex subject is that physical injury damages are almost always non-taxable for state and federal purposes.
But remember: Any award that is not originating from physical injuries will be considered taxable by Uncle Sam. So plan your taxes accordingly.