Is Your Personal Injury Settlement Taxable?

Personal Injury Lawsuits

Personal injury cases tend to drag on for months or even years, but the vast majority settle either before or during trial.

A case is resolved once you accept a settlement offer and sign a release form from either the insurance company or the defense attorney.

What comes next, then?

Ideally, you would receive your money promptly, minus your lawyer’s contingency fee, and resume everyday life.

You should also consider whether the government might be entitled to a portion of your settlement. This guide highlights some of the income tax issues applicable to personal injury settlements so you can proceed with confidence and get the compensation you deserve.

Physical Injury Settlements Are Not Taxable

As a rule, the proceeds from personal injury claims are not taxable under either federal or state law.

Regardless of whether you settle your case before or after you file a personal injury lawsuit, and even if you go to trial and win, neither the state nor the federal government, through the IRS, can tax you. They cannot tax the settlement or the verdict proceeds.

Federal tax law excludes damages resulting from personal physical sickness or physical injuries from a taxpayer’s gross income.

This means that damages in personal injury cases are intended to compensate the claimant for all of the following:

• Lost income
• Medical bills
• Pain and suffering
• Emotional distress
• Loss of consortium
• Attorney fees

None of the above are taxable if they stem from either physical sickness or personal injury. Physical sickness, in this sense, means a claim for an illness—after being negligently exposed to germs that made you sick, for instance. Any damages recovered for physical sickness are not taxable.

As with all rules, there are exceptions when it comes to income tax.

Exceptions to the Rule

If you suffer from physical sickness or physical injury, you will not be taxed on any damages relating to a breach of contract, assuming the breach of contract is responsible for your injuries and forms the basis of your lawsuit.

Punitive damages, on the other hand, are always taxable. If you are involved in a claim for punitive damages, your attorney will typically request that the judge separate the verdict into punitive and compensatory damages. You can then readily prove to the IRS that part of the verdict was for non-taxable compensatory damages.

Interest on a personal injury judgment is taxable. In many states, court rules add interest for the length of time your case has been pending.

As an example, if you filed suit on January 1, 2020, you would typically receive interest on the verdict commencing on January 1, 2020, and running until you receive payment. If you won at trial on January 1, 2021, but the defendant appeals and does not pay you until March 30, 2022, you would receive interest amounting to two years and three months on the total amount of the unpaid verdict. This interest is taxable.

Claims Limited to Emotional Injury

Any verdict or settlement for a personal injury claim is non-taxable only if it stems from a physical injury. If you have a claim for employment discrimination or emotional distress but no accompanying physical injury, you can expect your verdict or settlement to be taxable. The only exception is if you can prove even the slightest degree of physical injury. Without this, the IRS will take its cut.

Make Sure as Much of Your Settlement as Possible Is Non-Taxable

Some people find themselves making two claims against a single defendant. One of these claims relates to a personal injury, and the other does not. If the personal injury component of the claim is significantly larger, you should ensure the settlement agreement specifies precisely what amount of your settlement relates to the personal injury claim and what amount relates to the non-personal injury claim.

It is possible for the IRS to challenge the taxable status of a personal injury settlement, so by allocating your settlement in this way, you will maximize your chances of keeping as much of your settlement as possible non-taxable.

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