When do you owe taxes on a personal injury settlement? Here’s what you should know to avoid costly surprises after the insurance company pays your compensation.
Most personal injury cases are settled out of court. A few cases go to trial, sometimes resulting in a huge jury verdict in favor of the injured party.
Whether you settled directly with the insurance company or beat the at-fault party in court, you may be left with a tax liability for all or part of the total settlement amount.
Find out when your medical costs, pain and suffering, lost wages, and other monetary awards are typically exempt from taxation, and when you’ll have to pay.
IRS Tax Rules on Injury Settlements
The federal government will have access to your settlement information. In many cases, the insurance company will submit a 1099 form to the IRS to report the amount of compensation paid to settle your claim.
Your settlement check and the accompanying release form may not show a breakdown of the damages included in your injury compensation. Insurance companies usually pay out one lump sum and leave it to you to allocate the different amounts.
IRS Rules on Settlement Taxability state, in part:
“Whether you must include the settlement proceeds in your income depends on all the facts and circumstances in your case. A settlement payment may consist of multiple elements that have been allocated by the parties. For example, an [injury settlement] may include payments for back pay, emotional distress, and attorneys’ fees.”
It’s up to you to accurately disclose all taxable amounts of your injury settlement and pay the taxes accordingly. Failure to report taxable compensation on your tax return can subject you to the same penalties as any other unreported income. Like it or not, you can’t escape federal income taxes.
Every personal injury settlement is different. Consult a tax professional for specific financial advice.
Taxable Income and Wages
If you lost time from work while recovering from your injuries, your settlement would include an amount to reimburse your lost wages.
You are required to disclose all income when filing your annual income taxes, including the “lost wages” portion of your injury compensation. The government expects you to pay income taxes, regardless of who paid your wages.
However, you need to know when the IRS counts other types of settlement compensation as “ordinary income” for tax purposes, including:
- Interest paid on the amount of your settlement
- Punitive damages
- Emotional distress
- Awards for non-injury claims, like a breach of contract
- Attorney fees where the underlying recovery is included in gross income
Punitive damage awards are taxable, although most injury settlements won’t include them. Punitive damages are awarded in high-dollar lawsuits, like defective medical device cases, to punish corporate wrong-doers.
We’ll explain the most common taxable portions of an injury settlement, and when compensation for medical expenses must be reported.
When are Medical Expenses Taxable?
All bodily injury claim settlements include reimbursement for medical expenses. Strictly speaking, this money is not taxable. Compensation for medical expenses only becomes taxable if you used those expenses for a tax deduction on your prior years’ tax returns.
Qualifying medical expenses are:
“[T]hose medical expenses incurred to diagnose, cure, treat, mitigate or prevent a disease, or for the purpose of affecting any structure or function of the body.”
Previously Deducted Medical Expenses
You may have had no choice but to pay out-of-pocket for medical treatment while your claim was pending. If so, when you receive your injury settlement, think about whether you’ve already taken a tax deduction for those medical costs.
If you used the costs of your injury treatment to count toward a medical tax deduction on a prior year’s tax return, even if you filed jointly with your spouse, you may have to treat that portion of your settlement as income.
Why Does the IRS Tax Medical Expenses?
Let’s say you paid for medical treatment out of your own pocket while your injury claim was pending, and then took the associated tax deduction. When you settled your claim, the settlement included reimbursement from the insurance company for those same medical costs.
Compensation for previously deducted medical costs is considered income because you’ve already had the benefit of a tax reduction for those amounts.
If you haven’t deducted those medical expenses on a previous tax return, then the amount paid to compensate you for those costs is not taxable.
Workers’ Comp Benefits Aren’t Taxable
You don’t have to pay any income taxes on workers’ compensation benefits you receive for a work-related sickness or injury, so long as the benefits are paid out under your state’s workers’ compensation law. Workers’ comp death benefits to survivors are also tax exempt.
If you go back to work under limitations, the wages earned will be taxable.
Compensation paid from third-party claims outside of workers’ comp will be treated as any other kind of settlement for tax purposes.
Beware of Taxes for Emotional Distress
Taxing authorities differentiate between pain and suffering awards associated with physical injuries and compensation for emotional distress that is not linked to physical harm.
A physical injury can be diagnosed in medical terms, but the pain and suffering associated with that same injury cannot. Nevertheless, that emotional suffering is as real as physical injury. The physical and the emotional are two parts of the whole loss. Any related compensation is not taxable.
Compensation for emotional distress is taxable when it’s not directly related to a physical injury.
Physical symptoms of emotional distress, like headaches or vomiting, don’t count as a physical injury, although compensation for your medical bills to treat those symptoms is not taxable.
IRS Description of Emotional Distress:
“If the emotional distress is due to a personal injury that isn’t due to a physical injury or sickness (for example, unlawful discrimination or injury to reputation), you must include the damages in your income, except for any damages you receive for medical care due to that emotional distress. Emotional distress includes physical symptoms that result from emotional distress, such as headaches, insomnia, and stomach disorders.”
Aside from emotional distress, any compensation awarded for something other than a physical injury, such as unlawful discrimination or injury to character, is taxable.
Attorney Fees and Other Tax Issues
Most injury victims hire an attorney on a contingency fee basis, meaning their attorney won’t be paid unless they settle their case or win a court verdict. The attorney’s fees are paid out of the victim’s settlement.
Some types of minor injury claims can be handled without an attorney, but for serious injuries, an experienced attorney is needed to get full compensation.
It’s easy to think of your “final settlement” as the amount you take home after attorney fees and costs are paid.
However, when the “cause of action” doesn’t involve a physical injury, like a wrongful termination lawsuit, the entire settlement amount may be taxable, including the percentage promised to your attorney. The government can consider the entire award as your taxable income before the attorney is paid.
Fortunately, when you have to include the entire settlement amount as income, your tax preparer can usually claim the attorney fees as a deduction.
It Pays to Talk to an Expert
Tax attorneys and certified public accountants can spend their entire careers interpreting sections of the Internal Revenue Code. If you have any questions about paying taxes on your settlement, set the money aside and talk to a professional.
If you anticipate a large settlement, ask your attorney about consulting a tax professional before the final agreement is signed. For example, if you expect to be paid years of future lost income, there may be settlement options that will lower your tax burden, such as a structured settlement.
Want to handle it yourself?
Contact Your Local IRS Office for taxpayer assistance online or over the phone.
Property Damage Payments: Compensation paid for vehicle repairs, or to repair or replace damaged personal items is not generally taxable.
State Taxes: Many states have their own income tax requirements. Check with your state tax authority if any part of your settlement is taxable, especially the portion paid for lost income.
Marketplace Healthcare Coverage: If you are enrolled in a healthcare insurance plan with a tax credit to offset your health insurance premium, your premium tax credit eligibility may be affected by an increase in taxable income. Visit Healthcare.gov for more information about healthcare and your federal taxes.
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