Does a Settlement Impact My Taxes?
Typically No, Many factors come into play when negotiating a personal injury settlement or seeking compensation in a lawsuit. One of your primary considerations is how much of the money will be there for you in the future when you need it. Numerous things may take a bite out of your personal injury compensation. For example, inflation in health care costs can devalue your settlement.
You do not have to worry as much about the effect of taxes on your personal injury compensation. For the most part, these are not subject to taxation. However, this is not an airtight rule for every aspect of your personal injury compensation. Get specific tax advice before you agree to a settlement so you understand the effect of federal and state income tax laws on your financial situation. Speaking with your personal injury lawyer can also provide insight on all the financial aspects of your settlement.
The Internal Revenue Code Taxes Income
The usual IRS rule regarding taxes comes from the United States Code. 26 USC § 61 states that “all income is taxable from whatever source derived unless exempted by another section of the Code.” The statute then lists several taxable things, including compensation for services and gross income from services for a business.
You know that the money you receive in a personal injury settlement is “compensation” because every lawyer tells you that you may be eligible for financial compensation after your accident. However, IRS law goes a little deeper than this. The first thing to do when you are wondering whether something is taxable as income is to see whether it fits either the definition of “compensation” in the Internal Revenue Code or an exception to the definition of income in the IRC.
Personal Injury Compensation Excepted from the Definition of Income
The good news for personal injury victims is that compensation for accidents falls into the latter category. 26 USC § 104 lays out an exception to the definition of income. This section is titled “Compensation for Injuries or Sickness.”
According to the law,
Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include…the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.
This section is the legal way of saying that your personal injury compensation is not taxable, whether you receive it in a settlement or from the jury. Note how broad the statutory language is here. The statute explicitly says “any damages.” The very broad definition means that federal income tax exempts anything you receive in a settlement agreement, no matter what it is for.
Personal Injury Compensation Pays You Back for What You Lost
Theoretically, a personal injury settlement pays you back for what you have already lost because of the accident. You have lost your health, property, and ability to work. In addition, you may have lost your emotional well-being and mental health because of your injuries. When you receive money for your damages, it makes you whole for your accident injuries. It is not a windfall for you that should be considered income.
This provision has been in the federal tax code for over 100 years. Although Congress has narrowed the tax-free status of some settlements and awards over the years, the exemption for physical injuries remains. While it is unclear why Congress included this in the Internal Revenue Code over 100 years ago, courts have completed some of the rationales.
Personal Injury Settlements Are Not Windfalls for You
According to the Supreme Court, a personal injury victim is not better off by receiving a settlement. The cost of an injury is human capital, for which an injury victim needs compensation.
In Commissioner of Internal Revenue v Glenshaw Glass Company, the Supreme Court characterized income as an accession to wealth. The law will not consider a personal injury settlement an accession to wealth because the person is no better off than before the accident. They are just being made whole by the damages.
There are some advantages to a personal injury settlement. Typically, when you earn wages from your job, they are taxed as ordinary income. According to the IRS, you do not have to pay income taxes on the money you receive as lost wages in a personal injury settlement. The only way that lost wages are taxable in a settlement is if they come from an employment-based lawsuit. If your cause of action is for personal injury, they are not taxable.
Logically, you might think that anything related to income will be taxable. However, personal injury victims get a break on taxes associated with lost wages, as they are something that stems from your personal injury and meets the exception contained in the Internal Revenue Code.
Most States Will Not Tax Your Personal Injury Compensation
There is further good news for personal injury victims who receive a settlement or jury award. While each state may have its own rules about income taxes, most of them will not tax your personal injury award. States will predominantly use the same income tax rules as the IRS. If your award is not taxable by the federal government, it is also not taxable by the state.
You May Need to Pay Some Tax for Lost Business Profits
Different tax considerations may apply when your personal injury compensation comes from lost profits from a business you run. Some personal injury victims are self-employed. In these cases, their settlements will include lost business profits for the time when they cannot run their business. This concept is similar to lost wages for an accident victim employed by someone else.
According to the IRS, there is a different tax treatment for lost business profits. Although you will not need to pay income tax on this part of your settlement, you will still need to pay self-employment tax. This payment is a significant expense that you need to be aware of when negotiating a personal injury settlement because you are responsible for a tax rate of over 12 percent. However, a portion of that returns to you as a tax credit.
In addition, you should also be aware of the tax treatment of emotional distress and mental anguish. Usually, these are a part of the personal injury damages you suffer. They deemed non-economic damages. In an ordinary personal injury case, emotional distress is, for tax purposes, the same as pain and suffering.
However, if the subject of your personal injury claim was emotional distress (and that was your personal injury), there will be a different tax treatment. If your personal injury was emotional distress, then the personal injury settlement you receive will be taxable.
You Must Pay the Government Back if You Took a Deduction for Medical Expenses
Another special tax rule for personal injury settlements is that you must pay any deduction for medical expenses back to the federal government if you receive a personal injury settlement.
If your medical percentages exceed a certain percentage of your income, you are entitled to an above-the-line deduction on your income taxes. However, if you then obtain a settlement, you will get a windfall because those medical expenses that you already paid are given to you by the defendant.
Therefore, you must reimburse the government for the tax break you received. However, since your health insurance has likely covered the bulk of your medical expenses thus far, this may be rare. However, between co-pays and your share of prescriptions, there is a chance that you may have exceeded the percentage that allows you to take a tax deduction.
There May Be Taxes for Some Workplace Injury Compensation
Further, some lost wages awards from workplace injuries may be taxable. For example, in a recent decision, the United States Supreme Court held that damages paid for an on-the-job injury are taxable under the Railroad Retirement Tax Act.
The Supreme Court’s decision looked at the definition of compensation that appeared in the RRTA instead of the one in the Internal Revenue Code. Therefore, car accident compensation will continue not to be taxable.
Nonetheless, you should know the source of your compensation if you suffered an injury on the job and need to know whether special tax rules may apply. An experienced lawyer will point out these considerations to you.
Make Sure to Consult a Tax Attorney, Accountant, or Financial Adviser
Even though personal injury settlements are usually tax-free, you should still seek financial advice if you expect to receive a large sum of money. Consult a financial adviser and an accountant so you know how to handle the influx of money. Your personal injury settlement includes money you will need in the future that you do not want to spend unwisely today. In addition, you do not want to get any unwelcome tax surprises in the future.
You should also consult a tax attorney. This post does not constitute tax advice, and an experienced tax attorney can determine whether the government will tax any part of your personal injury settlement.
If you expect tax issues with a personal injury settlement, see an attorney before agreeing to the deal. An attorney may structure the deal to make less of it taxable. Unfortunately, the IRS may look beyond the settlement agreement’s language and form its own opinion about what it may tax. However, getting tax advice ahead of time can help you avoid pitfalls that may result in an unexpected IRS bill.
Consult a Personal Injury Lawyer
Get an experienced personal injury lawyer before you agree to any settlement offer. An attorney can help you negotiate a favorable settlement, and they can also point out any legal issues that you may face in connection with your compensation. The personal injury process is complex enough that you should never handle these things yourself. It can only cost you money because you may make a mistake or be taken advantage of by the insurance company.
Too many people end up with far less than they need or deserve because they did not seek legal advice before accepting an injury settlement. Never risk leaving money out there that you need to cover your losses – now and into the future. Instead, seek legal help right away.