Personal injury cases tend to drag on for months or even years, but the vast bulk settle either before or during trial.
A case is resolved as soon as you accept a settlement offer and sign the release form, either from 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 you could 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, neither under federal law nor 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 in the form of the IRS can tax you. They cannot tax the settlement and they cannot tax the verdict proceeds.
Federal tax law excludes the damages resulting from personal physical sickness or physical injuries from the gross income of taxpayers.
This means that the damages for 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 come 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 should not be taxable.
As with all rules, there are exceptions to this rule when it comes to income tax.
Exceptions to the Rule
If you suffer from physical sickness or physical injury, you will be taxed on any damages relating to a breach of contract, assuming the breach of contract is responsible for your injuries, and also that the breach of contract 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 always request the judge to separate the verdict into punitive damages and compensatory damages. You can then readily prove to the IRS that part of the verdict was for non-taxable compensatory damages.
Interest on the judgment of a personal injury verdict 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 interest would run until you receive payment. If you won at trial on January 1, 2021, but the defendant then appeals and doesn’t finally pay you until March 30, 2022, you would receive interest amounting to two years and three months on the total amount of any unpaid verdict. This interest, then, is taxable.
Claims Limited to Emotional Injury
Any verdict or settlement for a personal injury claim is only non-taxable as long as it stemmed 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 would be if you could prove even the slightest degree of physical injury. Without this, the IRS will take their cut.
Make Sure as Much as Possible of Your Settlement is Non-Taxable
Some people find themselves making two claims against a single defendant. One of these claims relates to a personal injury and one does not. If the personal injury component of the claim happens to be 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 as possible of your settlement non-taxable.