When you receive a settlement, you need to know what to expect. Part of your planning should include an understanding of the tax burden on your settlement.
Are personal injury settlements taxable?
Our experienced Greenville personal injury lawyer at Bobby Jones Law explains what you need to know.
Are Personal Injury Settlements Taxable Under Federal Law?
Personal injury settlements are not taxable under federal law, except for punitive damages and interest. Compensatory damages for personal injury, including economic and non-economic damages, are tax-free for United States federal taxes.
This rule applies only to personal injury cases. If a case is for emotional distress, even if it affects the person physically, it falls under a different set of rules.
When Are Settlement Funds Tax-Free?
Settlement funds are tax-free when they are paid on account of personal injury or physical sickness.
Generally, all income from any source is taxable as gross income. 26 U.S.C. § 104 creates exceptions. One of the exceptions is for damages arising from personal physical injuries or sickness.
The IRS and the courts interpret the law broadly to cover many different types of personal injury compensation.
Damages that are excluded from taxation include:
- Medical bills
- Lost wages
- Property damage
- Pain and suffering
- Disability
These types of compensation are considered restorative of what the person lost due to the personal injury. If the amounts were taxed, the person wouldn’t truly be made whole.
There are a few things that are taxable:
- Punitive damages
- Interest (pre-judgment and post-judgment)
Note: Compensation for medical bills may impact taxes if a deduction was taken for medical expenses in previous years. An attorney can explain if this may affect you based on your tax payments to date.
Does it make a difference if it’s a judgment or a settlement?
No. Taxation of a personal injury award is the same whether it results from a judgment or settlement.
Does it make a difference for taxes if it’s a lump sum or periodic payments?
No. Taxation rules for personal injury settlements are the same whether the award is a lump sum or a periodic payment.
When a settlement is subject to tax (including punitive damages and claims other than personal injury), stretching the payments out over several years can be an effective tax strategy.
Do You Owe Taxes on Lost Wages from Personal Injury?
If your claim is truly a personal injury claim, you don’t owe taxes on portions paid for lost wages. This is true only when the lost wages are paid in connection with an underlying personal injury. For legal claims that don’t involve physical injury, lost wages are usually taxable.
For example, you suffer a physical injury. You bring a personal injury claim. Because of your injuries, you’re unable to work for three months. You claim these amounts as lost income. The award is not taxed.
It might seem like lost income should be taxable because you would have paid taxes on the income you would have earned. But that’s not how U.S. tax law works.
Note: There’s a lot of confusion on this question. The distinguishing factor is the underlying physical injury. When a claim doesn’t involve physical injury, like employment-related claims, emotional distress, etc, lost wages are taxable. See Rev. Rul. 85-97, 1985-2 C.B. 50.
Why Are Punitive Damages in a Personal Injury Claim Taxed?
Punitive damages from a personal injury claim are taxed because they aren’t considered to result from the personal injury settlement itself. Punitive damages are awarded because of the offensive behavior of the defendant, rather than because of the defendant’s specific losses. For this reason, punitive damages are taxed, even though most other parts of a personal injury award are not taxed.
Do You Owe Taxes on Emotional Distress Compensation?
Emotional distress compensation is not taxed if the funds are paid because of an underlying physical injury. Funds for emotional distress without an accompanying physical injury are taxed. The distinction is important, so carefully evaluate the type of claim.
Are Personal Injury Settlements Taxable in Greenville, South Carolina?
South Carolina generally follows federal tax rules and applies graduated rates. There are modifications and exceptions, but personal injury compensation is not addressed. Greenville, SC, does not have a local income tax; therefore, tax treatment of a personal injury settlement should be the same for federal, South Carolina, and Greenville, SC purposes, subject to state-specific income tax rates.
How Settlement Structure Can Impact Tax Liability
Working with the defense to structure an advantageous award is allowed. Sometimes, it’s better to accept a lower amount that is not taxable than a higher amount that will be taxed.
Increasing compensatory damages and lowering punitive damages can minimize taxes, for example. In addition, minimizing interest payments can also be advantageous. But remember that the parties must be honest in how they designate settlement funds. A tax tribunal can look past the wording used in the settlement to determine what the funds represent.
Why Talk to a Lawyer
Tax planning can be important early in the case. When a claim qualifies as a personal injury case, the tax question is often not as consequential because, in most cases, only punitive damages and interest income are taxed.
In other types of cases, the tax burden can be significant. Compounding the problem is the fact that attorney fees are contingency-based. In those cases, the plaintiff may pay tax on 100% of the funds, even when a significant portion is paid to the attorney. Although this isn’t likely to be the case in a true personal injury case, a lawyer can provide assurances about tax treatment in your specific situation.
When the circumstances are complex, the answer to the question of taxability can be complex, too. For example, in Blum v Commissioner, the Tax Court ruled that funds received in a legal malpractice claim were taxable, even though funds from a successful personal injury claim would not have been. Ask your attorney for a personalized consultation.
Contact an Experienced Greenville Personal Injury Lawyer
If you’re injured in a personal injury accident, it’s important to know what taxes you’ll pay on the settlement. We encourage you to contact an experienced Greenville personal injury lawyer at Bobby Jones Law. We know the rules for whether personal injury settlements are taxable and can evaluate how the laws apply to your case.
Call or message us now.
