Posted On April 14, 2015 Personal Injury
With the deadline for filing your 2014 taxes with the IRS fast approaching, it’s the perfect time to answer a question that’s on the minds of many personal injury claimants: will they have to pay tax on their settlement or judgment?
The intersection of income taxes and the legal system is so complex that the IRS has written a 30+ page guide on the subject. Fortunately, the answers you need are generally a lot simpler.The IRS treats settlements and trial verdicts the same. Typically, most types of money damages you might receive from a personal injury claim are nontaxable, but there are exceptions.
In the case of most personal injury claims, your damages are what we call compensatory – in other words, they’re meant to compensate you for something you have lost, whether that’s the money you’ve spent on medical expenses or income that you have missed out on because of your injuries.
“Generally speaking, most people view the term ‘compensatory’ to mean ‘nontaxable,’” the IRS reported, but that’s not entirely accurate. “The term ‘compensatory’ merely means that the payment compensated the taxpayer for a loss… determinations of the taxability of lawsuit awards cannot always be made by simply referring to the terminology used.”
So what does this mean for you? Let’s break it down.
Typically, any money you receive is considered income unless the tax code specifically excludes it. That’s why it’s important to know whether or not parts of the compensation you receive from pursuing a personal injury claim fall into an excluded category of income.
Section 104(a)(2) of the tax code specifically excludes “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” from an individual’s gross income.
In other words, the money you receive for your physical injuries in a settlement or judgment is not subject to income tax. Same goes for any compensation for emotional distress related to your injuries.
However, if you deducted medical expenses related to your injury from a previous year’s taxes, you may have to include this amount as “other income,” according to the IRS. Basically, you can’t get that money tax-free if you’ve already gotten a tax benefit from it once.
You’ve probably heard the phrase pain and suffering, but you might not have a clear idea what it means. Compensation for pain and suffering means money to repay you for the physical and emotional distress you have suffered from the accident or your injuries, including how your injuries have affected your life. Like physical injuries, pain and suffering is another type of damages that is considered nontaxable. So is loss of consortium, or the loss of marital companionship between spouses, NOLO reported. While these damages are considered non-economic damages, meaning that there isn’t a set cost attached to them the way there is to medical expenses, they are still compensated monetarily – so it’s important to know that you won’t have to pay income tax on them.
Sometimes plaintiffs receive what’s called punitive damages, or money awarded as punishment for the wrongdoer rather than money awarded only for the purpose of repaying the victim. Not every claim involves punitive damages. They mainly come into play in situations in which (1) the defendant’s behavior was especially heinous or outrageous in some way, such as committing a hit-and-run, and (2) the case went to trial. In the (in)famous McDonald’s coffee case, jurors decided to impose punitive damages on McDonald’s for what the jury perceived as the company’s lack of concern for the more than 700 customers who had complained of burns from excessively hot coffee.
Punitive damages can be very high. McDonald’s, for instance, was originally ordered to pay $2,700,000 in punitive damages before the judge decided to reduce the amount. However, these damages are taxable – so if your case does include an award for punitive damages, don’t spend all of that money right away. Punitive damages are “always” taxed, Forbes reported, so expect the IRS to come after its cut. The same goes for any interest you are awarded at a trial, so take stock of what you might owe before spending that money.
If your case didn’t involve punitive damages and you never took an itemized medical deduction for expenses related to your accident, it’s likely that your settlement is tax-free in its entirety. Even so, though, you should know about the other costs you might have to pay: liens. The simplest way to describe a lien is as money that you owe.
When it comes to your claim, it’s important to know what expenses – whether taxes or liens – you will have to pay on a settlement or judgment. After all, you want to keep as much money in your pocket as possible – and you don’t want to find out too late that you owe money you have already spent.