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When bills pile up after an injury, the idea of a settlement to cover your losses can seem like a dream come true. The good news is most personal injury settlements in California are not taxable. In rare cases, you may only owe taxes on part of your settlement.
You may need clarification on personal injury laws. Take your time. Even an expert may need help understanding the laws when tax regulations are involved. Thankfully, our personal injury attorneys at Arash Law, led by Arash Khorsandi, Esq., have lots of experience. So, 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.
Most of the types of lawsuits are taxable. It means the party who successfully claimed compensation must give the Internal Revenue Services (IRS) a certain percentage of the monetary settlement or award. What makes a personal injury case different from other kinds of lawsuits is that you owe nothing to Uncle Sam when you recover any money for your injuries.
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.
In an ideal world, you would quickly get the money, deduct the attorney’s fees, and move on with your life. But what if the government demands a share of your settlement? How do you know when it is proper? Let’s see a few income tax issues that 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 won in personal injury cases to be excluded from gross income when you file your taxes. In other words, whenever you receive a personal injury award for personal physical injuries or illness, you don’t need to report them as income. The tax-free benefit applies to compensation paid in 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 exemption to the general rule, punitive damages, interest on an award, and awards over damages are taxable by the IRS.
Taxing awards are subject to the following additional IRS guidelines:
- Lost wages. Since victims pay taxes for their income, the IRS may tax victims on an award for lost earnings. However, the victims are not taxed if the lost wages are due to physical injuries.
- Emotional distress. It is taxable if the award of damages is solely based on emotional or mental anguish.
- Medical expenses previously claimed. Medical expenses related to an accident must be reported to the IRS if the expenses are reported on a previous tax return.
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 there is an exception in most personal injury cases. 26 C.F.R Part 1 contains the most 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 Is 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 payback 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 provides a plaintiff can obtain punitive damages 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, wanton, 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 on top of compensatory damages.
“The primary purposes of punitive damages are punishment and deterrence of [malicious and similar] conduct by the wrongdoer and others.” (Grimshaw v. Ford Motor Co. (1981). In the preceding case, where Ford decided against fixing a defective component after finding that paying liability claims is cheaper, the court said punitive damages are “the most effective remedy for consumer protection against defectively designed mass-produced articles.”
Unlike compensatory damages, punitive awards are taxable. But the IRS warned this is not a hard and fast rule. The American Bar Association argues 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 concerning 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, like 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, their family members are entitled to file for wrongful death claims. The victim’s family may receive compensation from the court for the loss of financial support, the victim’s pain and suffering before death, medical and burial costs, and the loss of an inheritance in the future.
However, punitive damages, as mentioned above, are frequently taxable. These compensating payments are not included in the income of the surviving family members.
Other Non-Taxable Settlements
Workman’s Compensation
Workman’s compensation, also called Workers’ Compensation, is awarded to compensate the medical expenses, lost wages, and rehabilitation costs to employees injured or become ill “in the course and scope” of their job. It also serves as death benefits to family members of employees who were killed on the job.
Some exceptions to the no-tax rule are:
- When the recipient 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. A skilled attorney can work out a compromise to lessen any tax impact.
Types of Taxable Settlements
Social Security Disability
There are instances when an attorney’s assistance is needed to obtain 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 occasionally be granted as a sizable lump sum reflecting prior payments. The IRS will seek taxes but does not punish SSDI recipients and instead permits an equitable payment plan.
The IRS multiplies other household income by half the amount of disability benefits to determine the taxes owed in a typical year. The amount must be less than $25,000 for single people to be tax-free. The $32,000 threshold or limit is for married people who file a joint return.
SSDI is not taxable in California, unlike 13 other states that tax SSDI.
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 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
Settlement for Criminal cases not involving injury will be subject to tax by the IRS. An example is when a robbery was committed, and the store was damaged, but the owner/victim sustained no injury. If the court orders the defendant to pay for the reconstruction of the store, the award is not exempted from tax.
Restitution is imposed by the court to cover actual crime-related expenses incurred by a victim. It is not the same as damages awarded as part of a civil suit. The victim may be awarded both civil suit damages and restitution, which is usually not taxable.
Cases of Emotional Distress
These are physical symptoms but not visible. The IRS will tax any settlement for intangible damages, including those caused by emotional suffering.
Headaches and stomachaches are common signs of emotional distress following an accident or traumatic event like a home intrusion. Although not visible, these bodily signs exist. Any compensation for intangible damages, such as mental anguish, will be subject to taxation by the IRS.
The exception to the rule is when emotional distress is related to physical sickness or injury. 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.
Additionally, the medical expenses incurred for emotional distress are not taxable, which may include expenses for counseling sessions.
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 is a wise decision before filing a complicated tax return, you can have an idea by learning these general rules:
- You don’t need to report the compensatory award as income if it was based on physical sickness or injury.
- You need to report any punitive damages or another taxable award as income.
- The lost earnings gained in a settlement, including its interest, must be reported in the tax return.
For taxable cases, the attorney fees are considered part of the awards. This means even if an attorney got a portion of the award, the IRS may tax the beneficiary for the entire amount.
According to experts, entering an agreement with the defendant over lawsuit-related tax issues might reduce this tax liability. Tax agreements between two parties in a lawsuit are generally not interfered with by the IRS. Therefore, holding onto more lawsuit dollars may be worth the effort. Award-winning personal injury attorneys at Arash Law, led by Arash Khorsandi, Esq., can help structure settlements to reduce their tax liability.
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. If you are suing for a physical injury caused by another’s negligence, the proceeds are not necessarily considered income and are taxed differently.
Attorney fees also factor in your income. If you obtain a $100,000 award for willful infliction of emotional distress, and your attorney’s fee amounts to $40,000, your “total income” will remain at $100,000.
Can I Avoid Paying Tax on My Settlement?
Your dispute and settlement may most likely involve several legal issues. It means you may have to pay taxes on some things but not others. Medical expenses are tax-exempt, even payments to a counselor or a psychiatrist. However, there are situations when the physical and emotional line becomes hazy.
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 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 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 allow 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.
Ensure That as Much of Your Settlement as Possible Is Non-Taxable
There might be two separate claims against the defendant, one relating to a personal injury, the other not. When dealing with such a claim, especially when the personal injury claim is much more substantial than the non-personal injury claim, you should 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.
Nearly all legal and tax regulations have exceptions. Before accepting a personal injury settlement, speaking with an experienced and skilled personal injury attorney is wise. The legal team at Arash Law, under the guidance of Arash Khorsandi, Esq., can analyze the tax implications of a particular personal injury settlement in-depth and bargain for better terms.
Call us today at (888) 488-1391 for a free consultation!
