Most personal injury cases are settled during or before trial. A settlement occurs when the parties involved in a legal dispute settle the case outside the courtroom. In a settlement agreement, both parties give up their right to pursue monetary recovery or legal action from one another. A personal injury settlement can be nontaxable, partially taxable or entirely taxable. Whether or not a settlement is taxable is dependent on the presence or absence of physical injury or sickness.
Physical Injuries are Not Taxable
The settlements from personal injury cases are not taxable. Federal tax law does not include damages from personal injuries or sickness from your income.
For instance, if you sustain injuries from a defective mowing machine and use $90,000 as medical expenses, if the mowing company awards you $90,000 in damages, the amount will be tax free.
A settlement whose damage award is based on mental anguish or emotional distress may also be tax free if the mental anguish and emotional distress is related directly to the physical injury or sickness. For instance, if you settle with a mowing company for an amount of $90,000 and get $60,000 in medical expenses and $30,000 for the mental anguish of living with a cast and daily pain, the $30,000 damage award will be non taxable since it is not directly related to physical injury.
Therefore, damages that compensate you for lost wages, emotional distress, medical bills, loss of consortium, attorney fees and pain and suffering are not taxable provided they resulted from personal injuries or physical sickness.
To every rule there is an exception and for the law on the taxable status of physical injuries, you may be taxed for damages resulting to the breach of contract if a breach of contract was the cause for your injuries and thus the basis for your lawsuit.
Punitive damages are taxable. Punitive damages apply where a person is awarded cash that is beyond the money that is paid for compensation of injuries. This award is meant to punish the guilty party. If you have a punitive damages case, your attorney will request the judge to separate his/her verdict into punitive damages and compensatory damages. This helps you prove to IRS that part of the damages were compensatory and therefore not taxable.
Interest on damages is taxable. In most states, the court may add interest to the final damages award due to the period of time the case has remained pending. For instance, if your suit was filed on the 1st of January, 2014, you will receive an interest on the final court decision starting from that period and up to the time you get paid. Therefore, if you won the case on 1st of Jan 2015, and the defendant paid you on March 2015, you will get one year and three months worth of interest and this amount is taxable.
Emotional Injury Claims
A settlement is non-taxable provided it is not a physical injury. For instance, if you claim emotional distress or discrimination at work, your settlement will be taxable unless you prove there was physical injury.
The same as defamation and wrongful discrimination, a settlement that is meant to compensate you for loss of income or lost wages is taxable income and should be reported to the IRS.
Ensure Most of Your Settlement is Non Taxable
There are cases where you may have two claims where one is related to personal injury and the other is not. In such instances, if the claim for personal injuries is larger than the claim that is not associated with personal injury, you need to explicitly show in your settlement, the amount that relates to your personal injuries and that which does not.
IRS will always dispute a settlement that is not taxable; therefore, allocating your settlement in this manner is your best chance of getting most of your damage amount excluded from taxation.
Whenever you get a personal injury claim, it is advisable to consult an attorney on issues involving taxation. Your lawyer will inform you on the taxable claims and non taxable claims and your available options. Moreover, your attorney will help you deal with the IRS when they attempt to have you pay taxes for non-taxable claims.