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In the United States, out-of-court settlements are the norm for personal injury cases, so accident victims often ask whether they must pay income tax on personal injury settlements. It makes sense to ask that, given that the Internal Revenue Service (IRS) appears to collect taxes on everything.
In my experience as a personal injury lawyer, the winnings from your injury case are not subject to taxes.
In this article, I will tell you more about the various injury settlement types and answer the question of whether your personal injury settlements are taxable or not.
Summary of the Key Findings
- Personal physical injury settlements are not subject to a tax deduction.
- The IRS will tax any settlement for intangible damages, including those brought on by emotional suffering.
- Taxes are typically levied on punitive damages but not on compensatory damages.
Does a Personal Injury Settlement Require Tax Reporting?
No, a personal injury settlement doesn’t require tax reporting. They are one of the few lawsuit types that are tax-exempt.
However, most settlements from other lawsuits are taxable, meaning the party winning the lawsuit must pay a portion of their reward to the IRS.
Most settlements and verdicts are not taxable under federal or state law. Neither the IRS nor your state can tax you on the settlement or verdict proceeds in most personal injury claims.
Federal tax law excludes damages from personal injuries or physical sickness from taxpayers' gross income. Both lump sum and recurring payments are eligible for this tax-free status.
Tax-Exempt vs. Taxable Personal Injury Settlement
- Damages for mental pain and suffering or emotional trauma are exempt from taxes related to physical sickness or physical injury.
- Lost wages must be claimed as income, even if they are related to a personal injury lawsuit.
- Punitive damages that are included in a personal injury settlement are frequently taxed.
Suppose a breach of contract caused your injury and is the basis of your lawsuit. In that case, you will be subject to paying damages related to that breach, even if it resulted in physical illness or physical injury.
"The full amount of your accident settlement is non-taxable. This means you should not include your accident settlement when declaring income."
- Steve Barnes, Personal Injury Attorney
Money awarded as compensatory damages is used to cover the victim's losses, including injuries, medical bills, and more.
The IRS distinguishes between punitive damages and compensatory damages when granting tax relief. It happens because "compensatory" damages are intended to make up for or restore a loss that has been experienced.
Taxes are typically levied on punitive damages but not on compensatory damages. According to the American Bar Association, that is not the set rule, and it depends on where the personal injury claim originated from [1].
Types of Taxable Settlements
According to the IRS, the proceeds of a lawsuit must be taxed in accordance with its objectives. Here are some examples of taxable court settlements.
Social Security Disability
Social Security Disability Income (SSDI) is taxable income, but often recipients aren't making enough money to owe the IRS.
Based on the previous cases I worked on, for you to be tax-free, the total must have an income below $25,000 for unmarried people and a joint income of $32,000 for married couples.
Compensation for Lost Wages
The court can occasionally include compensation for lost income in settlements. A personal injury case that seeks compensation for lost wages or an employment-related lawsuit may involve wages [2].
Awards for Criminal Justice
Criminal justice cases that do not involve any physical injury or harm will not be considered taxable by the IRS because it is considered restitution for the damages.
A victim may receive civil suit damages and restitution for the consequences of a crime.
Based on the New York State Bar Association, restitution is not taxable.
It can also include lost wages, damaged property, and medical expenses.
Cases of Emotional Distress
The IRS will tax any settlement for any damage that is not tangible, including those caused by emotional suffering. These are physical symptoms but not visible. An accident or ordeal can cause emotional distress, with symptoms like headaches and stomachaches.
Types of Non-Taxable Settlements
Two kinds of cases fall under the category of personal injury and are typically exempt from taxes.
Wrongful Death Claims
Wrongful death claims are filed by family members when there has been a wrongful act, neglect, or defect in taking a life. A court may compensate families for the loss of financial support, emotional pain and suffering, medical expenses, and loss of inheritance.
Workman's Compensation
Most workers' compensation awards are not taxable either at a state or federal level.
Related Article: Are Lawsuit Settlements Taxable?
Ways to Avoid Paying Tax on a Settlement
There are three main ways to eliminate or reduce tax liability arising from a personal injury settlement:
- The first way is to save money by ensuring the funds are paid gradually over time.
- The second is to employ a tax planning strategy to minimize tax liability's effects.
- The third way is to delay settlements to enable full financial recovery of payments, allowing claimants more scope in paying taxes.
Related Article: How Are Personal Injury Settlements Calculated?
How Does the IRS Collect Settlement Taxes?
The IRS collects settlement taxes by either negotiating with you or establishing a payoff plan after reviewing your case and classifying you as eligible for such a thing.
As with any income, you must notify the IRS when submitting your tax return for the previous year because the IRS can know about your settlement from the insurance company.
The general rule is as follows, though it's always a good idea to speak with an accountant before submitting a more complicated return.
Read Also: How Long Does it Take to Get a Settlement Check?
Personal injury attorney fees are considered part of the award in taxable cases. In other words, even if an attorney received a portion of the settlement, the IRS may tax the recipient for the full amount of the award.
I suggest entering an agreement with the defendant over lawsuit-related tax issues to trim this debt. Experienced personal injury attorneys can help in designing settlements in a way to reduce their tax liability of them.
Related Articles:
See the other personal injury and accident lawsuits we've covered.
FAQs
Are Personal Injury Settlements Taxable?
No, personal injury settlements are not taxable. You do not need to report as income any personal injury award or settlement you receive from a lawsuit.
How Can I Avoid Paying Taxes on a Settlement?
You can avoid paying taxes on a settlement by disbursing payments gradually. Your income may move into a higher tax bracket if you receive a sizable taxable settlement. You can lower the amount of income subject to the highest tax rates by distributing your settlement payments over a number of years.
What percentage of a settlement is taxed?
The percentage of a settlement is determined based on your ordinary income. Your tax bracket determines the tax rate. In 2018, if you're a single person, you pay a 24 percent tax on income over $82,500.
Will I get a 1099 for a lawsuit settlement?
You will not get a 1099 if the money you receive from your legal settlement—such as for physical injuries—is tax-free.
Are You Unsure About Your Tax Obligations?
Our experienced tax attorneys can ease your concern about the taxes related to your settlement.
Contact the Schmidt & Clark, LLP law firm for a free legal consultation session with our team of the best personal injury lawyers. They will provide you with a free case evaluation and establish a solid attorney-client relationship to help you with what you need.
References:
- https://www.americanbar.org/groups/business_law/publications/blt/2017/04/05_wood/
- https://www.irs.gov/pub/irs-pdf/p4345.pdf