Personal injury settlements are one of the few types of lawsuits that are tax exempt. Most other lawsuit settlements are taxable, meaning the party winning the lawsuit must give a portion of their compensation to the IRS.
Are Personal Injury Settlements Taxable?
The IRS allows settlements won in a personal injury case to be excluded from gross income when filing taxes. This tax-free status applies to both lump sum and periodic payments.
Tax-exempt vs. Taxable Personal Injury Settlement Factors:
- Damages for emotional distress and mental anguish are tax free when linked to physical sickness or injury.
- Lost wages, even those connected to a personal injury lawsuit, do have to be claimed as income.
- Punitive damages are typically taxable when linked to a personal injury settlement.
Taxable Punitive Damages
Compensatory damages are funds awarded to compensate the victim for injuries, medical bills, and more. When it comes to tax relief, the IRS draws a line between compensatory and punitive damages. This is because “compensatory” damages are meant to compensate or pay back for a loss someone has suffered.
In the eyes of the IRS, a personal injury victim has suffered a loss equal to his or her compensated gain (the “damages”). So, there is no net gain and therefore no taxable income.
Punitive damages may be allotted in cases of willful, wanton, or reckless behavior that leads to injury or death. Punitive damages are punishment for wrong-doing and aren’t meant to “compensate” for a victim’s loss. They are considered rare; but they may be awarded on top of compensatory monies.
Generally, punitive awards are taxed, but compensatory damages are not. However, the IRS warns this is not a hard and fast rule. Much depends on the origin of the claim, explains the American Bar Association.
Types of Non-Taxable Settlements
There are many types of cases that fall under the personal injury umbrella and generally are not taxable. A sampling of these cases follows:
- Dog bites and attacks
- Motor vehicle accidents in respect to physical injury, not property damage
- Medical malpractice suits based on physical illness or physical sickness
- Premises liability cases where injury results from property or building neglect (An example might be an icy walkway that causes a slip and fall injury.)
- Workplace and construction injuries
- Product liability like a car with a dangerous flaw
- Defective medications, such as a drug with a side effect that causes serious harm
- Wrongful death cases
Wrongful Death Claims
Wrongful death suits are personal injury lawsuits filed on behalf of family members when there has been a wrongful act, neglect, or defect taking a life. The court may compensate families for loss of financial support, pain and suffering the victim endured before death, medical and funeral expenses, and loss of a future inheritance.
These compensatory damages are excluded from income for the surviving family members but punitive damages, as stated above, are commonly taxable.
Other Non-Taxable Settlements
Most workman’s compensation (also called worker’s compensation) awards are not taxable at the state or federal level. This tax break includes a worker’s compensation award given to survivors following an employee’s death.
Some exceptions to the no-tax rule include:
- Cases where the recipient previously deducted medical expenses from a related occupational sickness or injury.
- Retirement benefits even if the retirement resulted from an injury.
- Any interest paid on the workman’s compensation award.
- Those who receive Social Security Disability Income, or Supplemental Security Income: A settlement may prompt a reduction in disability benefits to meet a certain financial threshold. Often, a skilled attorney can structure a settlement to minimize any tax impact.
Types of Taxable Settlements
Social Security Disability
At times, someone might seek an attorney’s help to obtain Social Security Disability Income (SSDI). This type of income is taxable. But often recipients aren’t making enough money to owe the IRS tax payments. The exception is when a spouse’s salary or other household income lands them in a higher tax bracket.
In some cases, SSDI may be awarded in a substantial lump sum reflecting back payments. Although the IRS will expect taxes, it does not penalize SSDI recipients but allows an equitable payment arrangement.
The IRS figures how much taxes are owed on a typical year by adding one half of disability benefits to other household income. To be tax free, the total must fall below a $25,000 threshold for unmarried people. Those who are married but file a joint return have a $32,000 threshold.
When it comes to New York and SSDI taxes, in addition to federal taxes, 13 states also tax SSDI—but New York State is not one of them.
Settlements for Lost Wages
Sometimes a settlement may include compensation for lost wages. Wages may be at stake in an employment-related lawsuit, or a personal injury case that compensated for lost income.
In general, this type of award is taxable, according to the IRS publication “Settlements—Taxability.”
Criminal Justice Awards
Criminal justice cases that do not involve injury will be considered taxable by the IRS. An example may be an armed robber who breaks up the victim’s store during his crime but causes no injury. If an award is made to fix the store, that will not be tax exempt.
According to the New York State Bar Association, the court also may grant a victim restitution for the consequences of a crime, including lost wages, damaged property, and medical expenses.
Restitution is not the same as damages awarded as part of a civil suit. In fact, the victim may receive both civil suit damages and restitution. Restitution usually is not taxable.
Emotional Distress Cases
Sometimes an accident or ordeal like a home intrusion can cause emotional distress, with symptoms like headaches and stomachaches. These are physical symptoms, but not visible. The IRS will tax any settlement for damages that are not visible, including those caused by emotional suffering.
The exception is when the emotional distress is connected to physical sickness or injury. Consider a car crash that breaks several bones but also leads to a severe anxiety disorder. That disorder will not be taxed on account of the broken bones.
How the IRS Collects Settlement Taxes
As with any income, the time to report to the IRS is when filing a tax return for the preceding year. While it’s always a good idea to consult an accountant before filing a more complicated return, in general, the rule is as follows:
- For those who get a compensatory award based on physical sickness or injury, there is no need to report this as income.
- For those with punitive damages or another taxable award, report it as income on the tax return.
- Also report lost wages gained in a settlement and any interest.
In these taxable cases, attorney fees are considered part of the award. That means the IRS may tax the recipient for 100 percent of the award, even if an attorney received some share of it.
To trim this tax debt, experts suggest entering an agreement with the defendant over lawsuit-related tax issues. Often the IRS will not interfere with a tax agreement between two parties in a lawsuit. So, it may be worth the effort to hold onto more lawsuit dollars. Experienced personal injury attorneys can be helpful in structuring settlements to reduce the tax liability of them.
How Much Does the IRS Tax a Settlement?
As noted here, some portion of a settlement is taxed just like income. Much will depend on the amount of the settlement and what taxable income bracket it landed the recipient in.
Take the situation where a taxable settlement and one’s regular salary combine for an income bracket of more than $82,500. As of 2018, a single person in that bracket would be taxed at 24 percent on such income.
Consult a New York Attorney Today
Working with a skilled attorney can help ease your concerns about taxes associated with your settlement. Sobo & Sobo has over 50 years’ experience to help your case go smoothly at every stage. Consultations are free. Call Sobo & Sobo today.
These programs are based on a certain income threshold. So in cases where the combined income (both disability benefits and workman’s comp) exceed the threshold, the benefits may be reduced accordingly.