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When bills accumulate after an injury, a settlement may help address your medical expenses and other losses. Most personal injury settlements in California are not taxable, though some portions may be taxable in certain situations.
Personal injury laws and tax regulations can be complex. Our personal injury attorneys at Arash Law have experience handling these matters and can help clarify your questions. Even though we can’t cover every tax circumstance, we can provide a general summary of how taxes may affect personal injury settlements and how they apply to your case.
Some types of lawsuit settlements are taxable, meaning the recipient may owe a portion to the Internal Revenue Service (IRS). However, many personal injury settlements for physical injuries or sickness are not taxable, with a few exceptions depending on the specifics of the case.
Personal injury cases are often resolved through settlements entered into by the parties before or during the cases. The case is considered closed once the victim accepts the settlement offer by the insurance company or defense attorney.
Ideally, you would receive your settlement, deduct attorney fees, and move forward. However, there may be situations where some of your settlement is subject to income tax. Below, we will discuss a few tax considerations that may apply to a personal injury settlement.
How Will You Know If Your Personal Injury Settlements Are Taxable?
First, let us understand the nature of the settlement given to a personal injury victim. In tax law, all incomes are taxable. So when you gain something, you have to pay a tax. Personal injury settlements are not taxable in general because the compensation a victim receives is not a gain but compensation for a loss or injury.
What Is The Significance Of The Fact That Personal Injury Settlements Are Not Gained?
Since personal injury settlement is not considered income, the IRS allows settlements in personal injury cases to be excluded from gross income when you file your taxes. In other words, if you receive a personal injury award for personal physical injuries or illness, you don’t need to report it as income. The tax-free benefit applies to compensation paid in a lump sum or installment payments.
Is There An Exception To The General Rule That Personal Injury Settlements Are Not Taxable?
Yes, there is. As an exception to the general rule, punitive damages, interest on an award, and awards over damages may be taxable by the IRS.
Taxing awards are subject to the following additional IRS guidelines:
- Lost Wages — Awards for lost wages are taxable if not related to physical injuries. If lost wages result from a physical injury, they are generally not taxed separately.
- Emotional Distress — Damages solely for emotional distress are taxable unless they are directly related to a physical injury or sickness.
- Medical Expenses Previously Claimed — If you previously deducted medical expenses that are later reimbursed through a settlement, that portion is taxable to the extent of the tax benefit received.
Which Tax Code Is Applicable To My Personal Injury Settlement?
Under the Internal Revenue Code (IRC Section 61), “all income is taxable from whatever source derived unless exempted by another section of the Code.”
The good news is that there is an exception in several personal injury cases. 26 C.F.R. Part 1 contains the relevant IRS regulation on whether settlement money from personal injury cases is taxable. It states, in pertinent part:
§1.104-1 Compensation for injuries or sickness.
(c) Damages received due to personal physical injuries or physical sickness — (1) In general. Section 104(a)(2) excludes from gross income 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. Emotional distress is not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2). Section 104(a)(2) also excludes damages not in excess of the amount paid for medical care (described in section 213(d)(1)(A) or (B)) for emotional distress.
Why Are Compensatory Damages Not Taxable?
Compensatory damages are monetary awards compensating the victims for injuries, medical expenses, and other economic losses. When discussing tax relief, it is essential to remember that the IRS draws a line between compensatory and punitive damages.
The IRS does not consider “compensatory” damages as income because they are meant to compensate or pay back for the loss suffered by the victims. There is no net gain and, thus, no taxable income for the IRS since the personal injury victim suffered a loss equal to their compensated gain (“damages”).
When Can Punitive Damages Be Awarded? Are They Taxable?
The right to a punitive or exemplary damages award in California is strictly statutory. Civil Code section 3294 states that a plaintiff may be able to obtain punitive damages in rare cases when it is proven by clear and convincing evidence that the defendant has been guilty of oppression, fraud, or malice.
Punitive damages may be awarded for willful or reckless behavior resulting in an injury or death. This award is a punishment for wrongdoing and isn’t meant to “compensate” for a victim’s loss. They are considered rare but may be awarded in addition to compensatory damages.
The primary purposes of punitive damages are punishment and deterrence of malicious and similar conduct by the wrongdoer and others. In this case, where Ford decided against fixing a defective component after finding that paying liability claims is cheaper, the court said that punitive damages are an effective remedy for consumer protection against defectively designed mass-produced articles.
Unlike compensatory damages, punitive awards are taxable. However, the IRS warned that this is not a hard and fast rule. The American Bar Association argues that a lot relies on the origin of the claim.
Types Of Non-Taxable Settlements
A large number of cases fall under the umbrella of personal injury and are not taxable as a general rule. Examples of these cases are as follows:
- Motor vehicle accidents involving physical injury, not property damage.
- Workplace and construction injuries.
- Premises liability cases where injuries are due to property or building neglect (an icy walkway, for instance, causing a slip and fall injury).
- Product liability (e.g., a car with a dangerous design or component flaw).
- Medical malpractice suits based on physical illness.
- Defective medications, such as a drug with harmful side effects.
- Dog bites and attacks.
- Wrongful death cases.
Wrongful Death Claims
When a person’s life is lost due to a negligent, careless, or intentional act, eligible family members may be able to file for wrongful death claims. The victim’s family may seek compensation for the loss of financial support, the victim’s pain and suffering before death, medical expenses, and burial costs.
Punitive damages are generally taxable and must be reported as income. In contrast, compensatory damages are generally not included in the income of surviving family members.
Other Non-Taxable Settlements
Workers’ Compensation
Workman’s compensation, also called workers’ compensation, is awarded to compensate the medical expenses, lost wages, and rehabilitation costs to employees injured or who become ill in the course and scope of their job. It also serves as death benefits to the family members of employees who were killed on the job.
Some exceptions to the no-tax rule are:
- When the recipient has previously deducted medical expenses for a related occupational illness or injury.
- Retirement benefits, even if an injury led to the retirement.
- Interest paid on a worker’s compensation award.
- Those who got their Social Security Disability Income or Supplemental Security Income. A settlement may result in reduced disability benefits to meet a certain financial threshold. An attorney can help address potential tax implications related to your case.
Types Of Taxable Settlements
Social Security Disability
There are instances when an attorney’s assistance may be helpful when applying for Social Security Disability Income (SSDI). This type of income is subject to tax. However, beneficiaries frequently don’t make enough money to pay taxes to the IRS. The only exception is if a spouse is in a higher tax bracket due to their employment or other household income.
SSDI benefits may be taxable at the federal level if the recipient’s combined income exceeds $25,000 for single filers or $32,000 for married couples filing jointly. Lump sum back payments may be taxed, but the IRS permits allocation across prior years and allows payment plans if needed. SSDI benefits are not taxed in California.
Settlement For Lost Wages
The lost earnings compensation is typically taxable since it would have been taxed if you were able to work under IRC Section 61. According to this section, all income is taxable, regardless of its source, unless exempted by another code section.
IRC Section 104 excludes taxable income concerning lawsuits, settlements, and awards. However, each settlement payment must be analyzed in light of its facts and circumstances to determine why the money was received. Some settlement amounts are not tax-exempt.
The critical question is, “What was the settlement intended to replace?”
Criminal Justice Awards
In criminal cases not involving personal injury, awards or restitution for property damage may be subject to tax, depending on the circumstances and the type of loss reimbursed. For example, if a court orders a defendant to pay for property repairs after a robbery, the taxability depends on whether the payment exceeds the property’s original value.
Restitution is distinct from civil damages, as each has different legal and tax implications. Restitution is a compensatory payment ordered in a criminal case, whereas civil damages are awarded in a civil lawsuit.
Whether or not restitution is taxable depends on what it is compensating. Restitution for personal physical injuries or physical sickness is generally not taxable. However, restitution covering lost income is only tax-free if the lost income is a direct result of a physical injury. Restitution for other items, such as punitive damages or emotional distress not stemming from a physical injury, would likely be taxable. Due to these complexities, each case should be individually evaluated by a legal or tax professional for its specific tax consequences.
Cases Of Emotional Distress
Emotional distress can manifest with various physical symptoms, such as headaches and stomachaches. However, the IRS generally does not consider these symptoms alone to be a “physical injury” for tax purposes. The IRS generally taxes any settlement for intangible damages, including those caused by emotional suffering, unless they are directly related to a prior physical injury or illness. Take the case of a car crash that breaks several bones of the victim and also results in a severe anxiety disorder. The condition will not be taxed because of the broken bones.
Compensation received for medical expenses, including those for emotional distress (such as counseling sessions), is generally not taxable if the emotional distress is related to a personal physical injury or physical sickness.
However, there is an important exception known as the “tax benefit rule.” If you previously claimed those medical expenses as an itemized deduction on a prior year’s tax return, the portion of the compensation that covers those specific expenses may become taxable income in the year you receive the settlement. This prevents you from receiving a tax deduction and a tax-free reimbursement for the same expense.
If the emotional distress is unrelated to a physical injury, the entire settlement amount, including reimbursement for medical expenses, is generally considered taxable.
How The IRS Collects Settlement Taxes
When you receive a settlement, you must include it in your tax return for the preceding year. Although consulting an accountant can be beneficial before filing a complicated tax return, it’s still important to remember these general rules:
- You don’t need to report the compensatory award as income if it was based on physical sickness or injury.
- Report any punitive damages or other taxable awards as income.
- The lost earnings gained in a settlement, including its interest, must be reported on the tax return.
In taxable cases, attorney fees are typically considered part of the total award, so the IRS may tax the beneficiary on the full amount, including the portion paid to the attorney. Settlement agreements may address tax allocation, but the IRS has the authority to review and potentially recharacterize these amounts. Our personal injury attorneys can assist in structuring settlements to address potential tax implications, helping you address these complexities.
How Much Will I Be Taxed On My Settlement?
Taxes are collected based on the origin of the claim. The proceeds are taxable if you were terminated from work and claimed lost wages. However, if you are suing for a physical injury caused by another’s negligence, the proceeds are generally not considered income and are tax-free under federal and California law. This includes compensation for medical bills, pain and suffering, and even lost wages, provided the lost wages are a direct result of the physical injury.
Attorney fees also factor into your income in taxable cases. For example, if you obtain a $100,000 award for willful infliction of emotional distress (which is generally taxable unless tied to a physical injury), and your attorney’s fee amounts to $40,000, your “total income” will generally remain at $100,000 for tax purposes. While you are taxed on the full amount, the ability to deduct that $40,000 fee depends on specific tax laws related to the type of claim you pursued.
Because tax laws related to settlements are highly complex, it is crucial to consult with a qualified tax professional or personal injury attorney to understand your specific obligations.
Can I Avoid Paying Tax On My Settlement?
Your dispute and settlement may involve several legal issues. It means you may have to pay taxes on some things but not others. Compensation for medical expenses related to physical injuries is generally not taxable, even payments to a counselor or a psychiatrist, unless previously deducted. The distinction between physical and emotional symptoms may affect tax treatment and be determined in the legal process.
For example, if your job causes you to get an ulcer, is that a physical or emotional symptom? This will be determined through the legal process. Since punitive damages are not intended to reimburse you for your loss, they will likely be taxable if you seek them in a psychological or physical injury lawsuit.
Important notes provided by the IRS:
- Interest — Interest on any settlement is generally taxable as “Interest Income” and should be reported on line 2b of Form 1040.
- Punitive Damages — Punitive damages are generally taxable and should be reported as “Other Income” on line 8z of Form 1040, Schedule 1, even if the punitive damages were received in a settlement for personal physical injuries or physical sickness.
- Estimated Payments — Some settlement recipients may need to make estimated tax payments if they expect their tax to be $1,000 or more after subtracting credits and withholding. Information on estimated taxes can be found in IRS Publication 505, Tax Withholding and Estimated Tax, and Form 1040-ES, Estimated Tax for Individuals.
- Health Insurance Coverage — If you, your spouse, or your dependent enrolled in health insurance coverage through the Health Insurance Marketplace and advanced premium tax credit payments were made to the insurance company, let the marketplace know if you have a change in circumstances, such as a taxable settlement increasing your income. Reporting changes allows the marketplace to adjust the amount of your advance credit payments, which helps prevent significant differences between your advance credit payments and the premium tax credit you are allowed. Find out more about the tax-related provisions of the health care law at IRS.gov/aca. See IRS Publication 5152 and report changes to the marketplace as they happen.
Contact Arash Law’s Personal Injury Lawyers For Legal Assistance
There may be two separate claims against the defendant, one for a personal injury and another for a non-personal injury matter. When dealing with such a claim, especially when the personal injury claim is much more substantial than the non-personal injury claim, it’s crucial to address the allocation of compensation. Clearly specify in the settlement agreement how much of the settlement is for the personal injury claim and how much is for the non-personal injury claim.
In general, legal and tax regulations have exceptions. Before accepting a personal injury settlement, consider speaking with our experienced personal injury attorneys to determine if it adequately covers all your losses. We can help you understand the tax implications of your personal injury settlement and assist in structuring and negotiating terms.
Our legal team at Arash Law handles a wide range of personal injury cases, including car accidents, rideshare collisions, slip-and-fall incidents, dog bites, and wrongful death claims. Call us at (888) 488-1391 for a free initial consultation.
