It’s tax season! If you have received a settlement or been awarded money for a personal injury case, it’s important to know if your personal injury compensation is taxable.
Whether or not you need to pay tax on personal injury compensation depends on the origin of the claim and the type of damages. While a tax professional can give you specific advice on your settlement or award, here are some general guidelines.
Economic Damages for Physical Injuries or Physical Illness
Typically, compensatory damages related to a physical injury or illness are not taxable – IF you did not take an itemized deduction for those medical expenses in prior years tax returns.
For example, if you were injured in a slip and fall accident, you do not need to report any compensation for medical bills, prescription medication, ambulance services, rehabilitative therapy, etc.
However, if you have already deducted those expenses in a prior year, you must include that tax benefit amount as “Other Income” when you are compensated.
Many cases involve compensation for non-economic damages such as pain and suffering, emotional distress and mental anguish. This is a bit more complex.
If your pain and suffering were directly related to a physical injury, it may not be taxable. For example, let’s say you were injured in a motorcycle accident and suffered broken bones, internal injuries, road rash, and other contusions. You may have been in extreme pain for several months, and suffered emotional distress and mental anguish due to the extent of your injuries.
In that case, you do not need to report your pain and suffering compensation amount as income. Again, if you listed related expenses (pain medication, psychological counseling costs, etc.) on a prior year’s taxes, you would still need to report the tax benefit as “Other Income.”
However, according to the Small Business Job Protection Act passed by Congress in 1996, “emotional distress shall not be treated as a physical injury or physical sickness.” So, unless your emotional distress claim is directly related to a strictly “physical” injury, it’s taxable, under Internal Revenue Code § 104(a)(2).
So, if you are a victim of sexual abuse and you successfully sue your abuser, you may receive a substantial payout.
However, unless you experienced and documented your actual physical injuries, you would be required to claim that amount as “Other Income” on your taxes.
There are instances of sexual abuse in which there is no physical injury, but the victim still suffers severe mental anguish. Still, by law, the abuse victim would not be able to exclude any compensation from their taxable income.
“If you’re compensated for emotional distress in a personal injury case, you may have to pay taxes on it. In 1996 Congress decided emotional distress shouldn’t be treated as a physical injury or sickness.”
If you think this seems unfair, consider this. If you are a victim of sexual harassment who has successfully sued your employer, a poorly-worded section of the 2017 tax reform bill means that not only will you pay tax on your compensation, but you’ll also pay tax on your attorney fee.
Let’s say you are awarded $100,000.00. Your lawyer receives 30%, and you keep the remaining $70,000.000. But you still must pay taxes on $100,000.00.
Your law firm also must pay taxes on the $30,000.00 it receives. If you think that sounds like double dipping, you’d be right.
The “Weinstein Tax” was meant to prevent the harassers from writing off settlements and legal fees related to their own illegal behavior. But due to the vagaries of tax law, it applies to plaintiffs as well. A bill called “Repeal the Trump Tax Hike on Victims of Sexual Harassment Act of 2018” has been introduced in Congress. In April 2018, and was referred to the Committee on Finance, where it still sits.
Compensation for Lost Wages
If you filed a claim against your employer for lost wages, your compensation is taxable, just as your income would have been. You would claim the compensation as “Wages, salaries, tips, etc.”
If you are compensated for lost profits from your self-owned business, you must declare it as you would have done otherwise, under “Business income.”
Compensation you receive for damage to property is not taxable if the amount doesn’t exceed the adjusted basis of your property. “Adjusted basis” means the original cost or value of the property reduced by depreciation, or increased by capital expenditures or upgrades.
If the amount does exceed the adjusted basis of the property, you would need to declare the excess amount as income under “Capital Gains and Losses.”
If your car was worth $50,000.00 when you purchased it in 2016, and was still in pristine condition when it was totaled by a drunk driver in 2018, the adjusted basis would be about $36,000.00, due to depreciation.
However, if you had just installed a new sound system worth $2000, the adjusted basis would be $38,000.00. If your compensation doesn’t exceed that amount, it is not taxable.
But let’s say you receive a $40,000.00 settlement. You would have to pay taxes on $2000.00.
Punitive damages are always taxable. Report them under “Other Income.”
Some states require adding interest to your verdict based on how long your personal injury lawsuit was pending. That amount is taxable and should be reported as “Interest Income.”
Judgments and Settlements are Taxed the Same Way
The above guidelines apply whether you negotiate a settlement with the other party without going to court, or are awarded the amount in a court case.
If you win a large settlement, your compensatory damages will probably involve more than one of the above categories. It’s advisable to talk to an attorney about tax issues before accepting a personal injury settlement. He or she may be able to reach an agreement with the defendant on allocating the payout to your benefit. While the IRS is not required to recognize these agreements, they are likely to do so.
If you have been injured in an accident and haven’t yet considered any documentation beyond a police report yet, tax implications should be among the least of your concerns at this juncture. You should instead contact the personal injury attorneys at TorkLaw for advice about a personal injury claim and putting yourself on the road to recovery.
Our experienced attorneys can help you receive a much larger settlement or award than you would on your own, and we can connect you with professionals who can help structure settlements to reduce your taxes if needed. Call us today for a free case consultation.