Are Personal Injury Settlements Taxable?
February 18, 2019 • Uncategorized
Whenever a person receives a windfall from either winning the lottery or a receiving a settlement from a lawsuit, tax implications always exist. Everyone must declare certain types of income by law, and personal injury plaintiffs who secure settlements and jury verdicts for damages may wonder about their tax obligations. Ultimately, the nature of the compensation and cause of the damages determine taxability on personal injury case awards.
What Is Tax-Exempt?
Generally, compensation resulting from a physical injury or physical illness caused by another party’s negligence is tax-exempt. A personal injury lawsuit can yield compensation for medical expenses, lost income, vehicle repair or replacement costs, and pain and suffering. Any damages resulting from personal injuries do not qualify for taxation. In most cases involving property damages such as vehicle accident lawsuits, insurance covers the cost of vehicle repair or replacement.
For example, if a drunk driver hits another driver and caused significant injuries and damages, those damages relate to the struck driver’s injuries, so any compensation recovered would be tax-exempt. However, if the struck driver received punitive damages due to the drunk driver’s illegal and egregious actions, those punitive damages are taxable.
Exceptions to the Tax-Exempt Rule for Personal Injury Settlements
Damages related to purely psychological injuries do not qualify for tax-exemption, either. If a plaintiff files a claim for emotional damages but did not sustain any physical injuries, any settlement or case award received would qualify for taxation. Another potential exception would be judgment interest. Sometimes, a plaintiff will secure a judgment but various legal issues prevent immediate payment of the awarded sum.
For example, a plaintiff files a lawsuit on January 1, 2019 but the case does not reach a conclusion until January 1, 2021. The defendant appeals the decision and ties up the court system for another year before meeting with a denial on his or her appeal on January 1, 2022. The court upholds that the defendant must honor the judgment, but the defendant does not start paying until January 1, 2023. In this situation, the judgment went into effect on January 1, 2021 and remained in limbo for an addition two years until associated proceedings concluded. The judgment accrues interest in this time, and the interest earned on a judgment qualifies as taxable income. Interest accrues from the time a claimant files suit until the defendant starts paying the judgment amount.
Minimizing Your Tax Obligation From a Personal Injury Settlement
It is possible for a personal injury case to involve several claims. For example, a plaintiff may file a lawsuit for a breach of contract as well as a personal injury. Unless the breach of contract directly led to the personal injury, only the compensation from the personal injury-related damages qualifies for tax exemption. If the breach of contract and not the physical injury form the basis of the plaintiff’s lawsuit, the resulting damages would qualify for taxation. If you intend to file several related claims against a defendant, it is essential to ensure your claim accurately reflects your claimed damages.
An attorney can help a client determine the best method for claiming compensation that minimizes the client’s tax obligation. The Internal Revenue Service always has the option of challenging the taxability status of your settlement or case award, so ensuring proper reporting is essential.
It is also important to remember that receiving a large settlement can potentially place you in a higher tax bracket if a significant portion qualifies as taxable income. This is another reason it is crucial for a personal injury settlement recipient to work closely with an attorney to determine his or her potential tax obligations and ensure appropriate reporting. Misrepresenting the amounts of damages pertaining to physical injuries as opposed to other causes can lead to severe legal penalties including fraud charges.