If you are collecting a personal injury settlement payment or judgment because you were injured in a car accident or hurt at work, you may be wondering if your recovery will be taxable income. The answer is usually no, but the taxes can vary enormously depending upon the damages, how the case was settled, and other variables. An experienced personal injury attorney can help guide you through the specifics for your case, but you should always consult with an experienced professional tax advisor. That being said, here are 10 basic things to know about the taxation of settlement payments.
Medical Expenses are Tax-Free
Even if your injuries are purely emotional, payments for medical costs are tax-free. Payments for a psychiatrist or counselor qualify, as do payments to a chiropractor or physical therapist. Many non-traditional treatments also count.
Recoveries for Personal Injuries Are Tax-Free
If you are suing for personal physical injuries such as a slip and fall or someone rear-ending your car, your damages are tax free. That might seem strange, since you are seeking lost wages because you couldn’t work after your accident, but a specific section of the tax code shields damages for personal physical injuries and physical sickness.
Allocating Damages Can Save Taxes
It’s almost always a good idea for the plaintiff and the defendant to try to agree on what is being paid and what will be its tax treatment. These agreements aren’t binding on the IRS or the courts, but they are often used if there is ever a tax dispute in the future.
Settlements and Judgments are Taxed the Same
The same tax rules apply whether you get paid to settle a case or win a judgment in a lawsuit. Despite being similar, you will almost always have more flexibility to reduce taxes on a settled case versus a judgment.
Distinctions Between Symptoms of Emotional Distress and Physical Sickness
The law draws a line between money you receive for physical symptoms of emotional distress and physical injuries or sickness; although these lines are not very clear. For instance, if you get $30,000 more in a settlement because job-related stress gave you an ulcer, is the ulcer physical or is it just a symptom of your emotional distress? You may have to pay for an outside tax expert, but you will usually save money later by spending a little now.
Capital Gain Taxes
Most settlement amounts will be counted as income, but if your lawsuit is about damage to your property, the settlement may be treated as capital gain and taxed at the rate of 15% instead of 35%. Depending on your tax basis, your settlement may be treated as recovery and not income.
Factor in Attorney Fees
Whether you pay your attorney by the hour or on a contingency basis, you should factor in the cost of your attorney when you are addressing taxes. If you are the plaintiff and use a contingency fee lawyer, you will usually be treated as receiving 100% of the money recovered by you and your attorney, even if the defendant pays your lawyer their percentage directly. If your case is fully nontaxable, that won’t cause any problems. If your recovery happens to be taxable, however, you will want to seek the help of a highly experienced tax advisor.
Interest and Punitive Damages Are Always Taxable
If you are injured in a car wreck and get $75,000 in compensatory damages and $3 million in punitive damages, the $75,000 would be tax-free and the $3 million is fully taxable. The same thing happens with interest. You’ll need a tax professional for assistance, but in some cases, you may actually be better off taking a smaller settlement amount for tax purposes.
The “Claims Origin” Can Affect Taxes
Settlements and judgments are taxed according to what the plaintiff was seeking recovery for. If you are suing your employer for discrimination and are seeking wages and severance, you will be taxed as receiving wages.
Consider the Defense Perspective
Plaintiffs are always worried about the taxes, but it may be worth it for you to also think about tax implications for the defense side. A defendant paying a settlement or judgment will always want to deduct it. If the defendant is engaged in a business or trade, that will not often be questioned since litigation is a cost of doing business. If the lawsuit is related to investments on the other hand, it may be deductible only against investment income or subject to a limit. If the suit is personal, the defendant may not get a deduction at all, which usually extends to attorney fees as well.
The bottom line on taxation of personal injury settlement payments: Before you resolve your case, talk to an experienced tax professional to make sure you’re doing what will be best for you and your loved ones.