Taxation of personal injury awards

Winning a personal injury settlement can be a relief. You can finally pay the bills that have been mounting up since your accident. Maybe you’ll finally be able to finish renovations on your home to make it more accessible. Whatever you need to do with your money, you might be concerned about Uncle Sam taking a chunk of it. It’s good that you are thinking about taxes. While the tax code can be confusing, there are some general rules when it comes to your personal injury claim.

The IRS

Personal injury settlements are not generally taxable under the IRS tax code. It used to be thought that the word compensatory related to non-taxable, but this is not the case. The terminology of the lawsuit is not what the IRS looks at when determining taxability.

According to the IRS:

“The facts and circumstances of each lawsuit settlement must be considered to determine the purpose for which the money was received. Then, it can be determined whether these amounts are excludable.”

However, your claim must have come from a physical injury or illness. This could include being exposed to a toxin. An emotional distress or a discrimination claim does not constitute a physical injury. You would need to pay taxes on your settlement if it was for these type of damages.

Any amounts you receive for property damage is non-taxable. This would be true for repairs or the reimbursement you receive if you rented a car while yours was being repaired.

Typically, the state follows suit. Your personal injury award will not be taxed in California.

The Situation Can Get Complex

When you’re working through a personal injury claim, you may have lost wages. The part of the claim that is awarded for your lost income falls under the income tax code. The reasoning is that you would have paid taxes on that income had you been working.

Punitive damages, while rarely awarded, are taxable. When you are being awarded punitive damages, the judge or your lawyer should ask that the amounts be separated. The compensatory damages, or personal injury distribution would be outside of the tax code.

Another portion of the damages is the interest, and this part of the award is typically taxable. For example, you filed your case in January 2014, but it wasn’t settled until December 2015. You could be awarded interest dating back to when your case was filed.

Legal fees are often deducted from the settlement. Generally, the IRS counts the whole settlement you receive, not what is given to you after the lawyer’s fees have been taken out. For instance, you were awarded $100,000, but after the lawyer took out their portion, you only received $60,000. The IRS would count your income as $100,000. This is a very complicated taxation issue. It gets more complex when you have interest or punitive damages. Many times, you can deduct your legal fees, but this can depend on the type of case.

Discuss Your Case With Experts

A personal injury lawyer will help you understand the breakdown of your case to have a better idea of which part of it is taxable in both the federal and state arenas. It would be worth your time to discuss your case with a tax professional who has more knowledge in the tax code. You don’t want the IRS or your state tax commission to challenge the taxability or non-taxability of your settlement. By taking care of your money, you’ll have peace of mind when it comes to your taxes and get the most out of your award.