Are legal settlements taxable? It is one of the most common questions clients ask after resolving a claim. A settlement to resolve a personal injury matter can be a cost-effective, time-efficient method to get your life back on track. Settlements can cover a wide range of compensation. These include lost wages, emotional distress, medical expenses, and punitive damages. Each category carries different tax treatment under the law.
How Settlements Aim to Make You Whole
The purpose of a personal injury settlement, whether for a car accident case or a truck accident, is to make you whole. The law treats it as compensation. It is not necessarily a reward for winning a case. For example, if you incur $25,000 in medical expenses, you may recover precisely $25,000 to cover those medical expenses. Additionally, if you miss time from work because of your injury and thus cannot earn a wage, you may recover compensation to cover that time missed. But what about the pain you suffer because of your accident? You get compensation for that, too.
However, you would not be made whole if you were to get taxed on the $25,000 you receive in compensation for your medical expenses. Thus, legal settlements escape tax because the IRS considers some types of compensation to be restorative rather than income. Plaintiffs generally receive more money in their pocket after the accident, that is, to compensate them for the months they had to deal with pain from an accident they did not cause. Thus, it is not income but compensation.
This differs from punitive damages, which the IRS taxes. We will explore the reasons below, but punitive damages aim to punish the tortfeasor rather than compensate the plaintiff. But what about lost wages? Should those not incur tax? If they escaped tax, would you not receive overcompensation? We discuss the rationale behind this below.
What Determines the Taxability of a Legal Settlement?
The taxability of a legal settlement depends on the nature of the claims involved and the types of damages awarded. The Internal Revenue Service outlines how it treats different categories of settlement proceeds. For example, your recovery stays tax-free if you only receive compensation for medical expenses and general damages. General damages include loss of enjoyment of life, pain, and suffering. However, 26 USC 104: Compensation for injuries or sickness makes several important notes on the taxability of a legal settlement. First, it states that gross income includes all amounts from any source unless a specific exception exists. The two most common exceptions are amounts paid for specific discrimination claims and amounts paid on account of physical injury. Taking this further, three elements under 26 USC 104 are worth closer examination.
- Physical injury and sickness damages generally remain untaxable. Per the Code, these damages are not part of gross income. This is true whether they are paid in a lump sum, as most settlements are, or as part of a structured settlement.
- Punitive damages, even when they form part of a legal settlement, typically incur tax.
- Emotional distress can trigger tax under IRC Section 104 and are therefore taxable. However, it is untaxable when the damages cover medical expenses related to emotional distress. If emotional distress results directly from a physical injury, those damages may also be non-taxable.
Taxability of Personal Injury Settlements
To understand the taxability of your personal injury settlement, you must understand how the value of your case is broken down. As we have discussed, the IRS taxes punitive damages, while compensatory damages are non-taxable. However, that bifurcation and specificity are generally only acknowledged in a trial. If your Maryland car accident attorney negotiates a settlement, the probability of punitive damages is considered. However, the insurance provider for the other side rarely lists, for example, $100,000 as compensatory damages and $300,000 as punitive damages. If it is simply one lump sum, it may be impossible to say whether any punitive damages were awarded. In fact, some insurance companies will say it is only $100 in punitive damages and $399,900 in compensatory damages to sweeten the deal. They know that a claimant does not want to pay those taxes, and that is a legal way for them to structure their offer.
Are Lost Wages in Settlements Taxable?
Lost wages that form part of a personal injury settlement remain non-taxable. However, this comes with caveats. Section 104 makes this clear under § 104(a)(2), which states “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” This section clarifies that it must relate to a personal injury such as a motor vehicle accident.
Accordingly, if your lost wage settlement is part of a discrimination settlement, it would incur tax.
However, this seems to contradict what we said about personal injury settlements being designed to make a plaintiff whole. Insurance companies generally only provide a plaintiff with what the injury victim would net after taxes to circumvent this. So, if a plaintiff has a lost wage claim of $10,000 but would have only brought home $7,000 after taxes but for the injury, then the claimant may only be entitled to $7,000 from the defendant.
How Are Punitive Damages Taxed?
The IRS taxes punitive damages as income. While they generally blend in and thus escape tax as part of a settlement, they will be taxed if they are part of a judgment against the defendant at trial. If you receive punitive damages, you must report them as “Other Income” on your tax return. The tax treatment of punitive damages highlights the importance of understanding the different types of damages in a settlement.
Tax Considerations for Settlement Interest
The IRS taxes interest from a legal settlement. Like punitive damages, the insurance provider may not specify a part of the claim as interest. However, if we go to trial, the judge may award interest on top of your damages. If we go to trial and you are awarded interest, you may be required to report the interest as income by submitting an IRS Form 1099-INT. Your personal injury attorney will advise you on what steps you need to take to ensure you remain compliant with the tax code.
Are Legal Fees Deductible?
A tax deduction is when an item or expense can reduce the amount you owe in taxes in a given year. Whether you can deduct legal fees depends on the type of case. You cannot deduct legal fees in personal injury cases when the settlement is non-taxable. However, if part of your settlement incurs tax, you may deduct the legal fees on your tax return as a miscellaneous itemized deduction. It is important to consult with your personal injury lawyer and potentially an accountant for information as it relates to your case. You may need to file a W-2 or 1099 form to report these details to the Internal Revenue Service.
Speak to an Attorney
For more information, contact Gelb & Gelb today. Our attorneys have been practicing personal injury law in Washington, D.C., and Maryland for over 70 years. During that time, we have gained a thorough understanding of whether legal settlements are taxable and how to maximize your settlement to best represent your damages. Our attorneys will help you through every phase of your claim. We have helped over 10,000 clients and stand ready to advocate for you. Contact our office today for a free consultation and case evaluation. Our phones are open 24/7.
