In the United States, most people pay taxes on money they earn in a given year. This can be money from their 9-5 job, money from stocks, money from an investment property, or even money from small neighborhood work, like babysitting or mowing lawns. However, the rules governing how much anyone pays in taxes are complicated and are dependent on several different factors.
Because personal injury settlements provide compensation designed to “make you whole again,” your settlement can be comprised of a number of different elements, each of which may be subjected to a different taxation rule. You may have a tax burden on none, some, or all of the money you receive as part of your settlement.
Here are the basic factors the IRS considers when evaluating taxes on a personal injury settlement. Your individual state may have similar or additional rules to consider regarding what, if any, tax burden you owe on portions of your personal injury settlement.
Physical Injury, Physical Illness, Emotional Distress, and Mental Anguish
A settlement meant to compensate for a physical injury, physical illness, or emotional distress, including pain and suffering, is not taxable and should not be reported as part of your income. This makes sense – it’s not money that you earned by working, it’s money that’s meant to make up for something that you lost.
However, if you itemize your medical expenses, including emotional or physical therapy, and received deductions for expenses related to the injury, you may need to repay the IRS the amount of the previously deducted expenses. Depending on the extent of the deduction, this may be pro-rated on your tax return for multiple years.
You should also note that interest on your personal injury claim is considered taxable, and should be reported to the IRS as interest income. This may be the case if you’ve engaged in a prolonged settlement negotiate with an insurance company, where you received compensation well after your initial injury occurred.
If you were out of work recovering from a car accident or another personal injury case, and you received lost wages as part of your compensation package, you likely need to pay taxes on this portion of the settlement. This money is considered taxable wages, because it’s meant to replace the wages you didn’t earn, due to your illness. Therefore, it should be reported to the IRS along with your other income for the year.
In addition to being subject to taxes, settlement money meant to make up for lost wages is also subject to social security and Medicare tax rates.
Often, part of the settlement for personal injury claims, especially in car accident cases, is for damaged or destroyed personal property. This can include the cost to repair or replace a vehicle, but accident victims also can receive settlement money for their clothes, cell phone, computers, or other personal items that were affected by the accident or injury.
You may or may not owe the IRS money for compensation of personal property. If the settlement was for less than the adjusted basis of the property, this money is likely not taxable. However, you would need to reduce the basis of the property in accordance with the settlement amount.
On the other hand, any settlement money over the adjusted value of the property is considered income and should be reported as a gain.
If the compensation was reimbursement for items such as car repairs, or for vehicle rentals while your car was in the shop, you do not owe taxes.
Money received from punitive damages is always taxable. This is not money that compensates you for a loss, or money that is meant to “make you whole again.” Instead, this type of compensation is meant to punish the other driver, their insurance company, or the company that caused your injury. Punitive damages should be marked as “other income” on your tax return.
This is a guest post by Matt Freeman. He is the managing partner of the Law Offices of Freeman and Freeman, headquartered in Santa Rosa, California. He has spent more than 20 years as a trial attorney working with personal injury plaintiffs across the state.