Taxes and Personal Injury Settlements
April 9, 2022
If you received a settlement at tax time, you might have questions. When you see your tax preparer, you can ask them a common question that our personal injury attorneys often get here at Zanes Law. The question is this: Do I have to pay taxes on the money I received from my injury settlement?
Because every situation is different, it’s possible. Legally speaking, though, It is pretty straightforward. If you received monetary compensation for your case resolution, whether it was from a trial, a settlement, or arbitration, and a portion of that money was specifically delineated for wage loss, then it could be taxable.
However, in most cases that the firm has worked on, there has never been a part of a case resolution that has specifically qualified for wage loss delineation, but the possibility exists. Let’s look at the implication of taxes on personal injury settlements.
Will You Have To Claim Your Settlement or Award on Your Tax Return?
Internal Revenue Code Section 61 establishes the basic rule for taxability of settlements and judgments or any payments received in the settlement of lawsuits and other legal remedies.
If part of your settlement is indeed taxable, you may be issued a Form 1099-MISC. This is one easy way to tell if you need to pay taxes on some of your settlements.
A 1099-MISC must be issued by the payer to the recipient if, over the course of a year, the beneficiary received more than $600 or if some part of the payment must be reported as income.
The good news is that physical injuries resulting from a court settlement are not subject to federal income taxation. However, there may be exceptions.
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What Part of a Settlement or Personal Injury Award Might Be Considered Taxable Income?
In certain circumstances, a personal injury settlement may be subject to taxation by the Internal Revenue Service (IRS).
The following are four instances where the IRS will tax a settlement for a personal injury:
Any compensation you receive in connection with the wages you lost because of your injury is another type of taxable income tied to a personal injury settlement. For instance, if you received a settlement that included a year’s worth of pay after missing a year of work due to an injury, that sum may be subject to taxation.
Since lost salary damages are directly correlated with your regular income, it is challenging to dispute the IRS on this point.
In particular cases, the defendant may be required to pay a personal injury plaintiff punitive damages. Punitive damages are not intended to cover a cost incurred but to further penalize the defendant for flagrant or criminal wrongdoing.
The IRS almost usually treats punitive damages as taxable income because they are not connected to a loss.
Non-Economic Damages That Are Unique or Unrelated to the Original Injury
The IRS may also tax non-economic damages that are unrelated to injuries. For instance, the IRS may tax the portion of your settlement that you get as compensation for the emotional distress you had as a result of the entire legal procedure surrounding your case – but which was unrelated to the original physical injury.
In some settlement agreements, the claimant consents to receive the money they are entitled to over a number of years, giving the defendant additional time to organize their finances.
With this condition, the settlement award is frequently treated as a loan with interest accruing over time on any amounts that are left unpaid. The IRS may tax any interest you receive on your settlement award, but they won’t tax the amount you were originally awarded as a settlement.
How the IRS Collects Settlement Taxes
As with any income, you must notify the IRS when submitting your tax return for the previous year. It is recommended that you get the advice of a professional accountant before submitting a more complex tax return, although, in general, the following holds true:
- There is no requirement to disclose compensation received as a result of bodily illness or injury as income
- Report any punitive damages or other taxable awards as income on your tax return if you have them
- Report any interest and any lost wages that you received from a settlement
- In many instances, legal expenses are included in the award and must be reported as income
Experts advise reaching a settlement with the defendant about the tax matters at issue in the lawsuit to reduce this tax liability. The IRS frequently won’t intervene in litigation involving a tax arrangement between two parties.
Therefore, maximizing the settlement money you can keep may be worthwhile. Personal injury lawyers with experience in structuring settlements to minimize tax liabilities can be useful.
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Make Sure That the Majority of Your Settlement Is Tax-Free
One of your claims against the defendant may not involve a physical injury. As some cases of emotional trauma can be taxed, it is important to specify in the settlement agreement, especially if the personal injury claim is significantly bigger than the other claim.
Allocating your payment in this way provides you the best chance of having most of it exempt from taxation, although the IRS can always argue the non-taxability of a settlement. If you need help with a personal injury claim or have more questions about personal injury settlements and taxes, reach out to the attorneys of Zanes Law for help.