When someone is injured due to an accident, whether it’s a car crash, slip-and-fall, or another event, they may seek compensation for medical expenses, lost wages, and pain and suffering through a personal injury claim. One common question that arises is whether personal injury settlements are taxable. The answer to this question depends on several factors, and it is important to understand the tax implications to avoid surprises later on.
Are personal injury settlements taxable ?
In most cases, personal injury settlements are not taxable in the United States. According to the Internal Revenue Service (IRS), money received as compensation for physical injuries or physical sickness is generally not subject to federal income tax. This includes both compensatory damages and punitive damages related to physical injuries.
Compensatory damages are awarded to make the victim “whole” again, covering expenses such as medical bills, lost wages, pain and suffering, and emotional distress related to the physical injury. These settlements are typically not taxed because they are intended to reimburse the injured party for their losses, rather than provide an economic gain.
Punitive damages, which are designed to punish the wrongdoer and deter future misconduct, may also be non-taxable if they relate to physical injury. However, in some cases, punitive damages may be taxable, depending on how they are classified and the circumstances surrounding the case.
When Personal Injury Settlements Are Taxable ?
Although most personal injury settlements are not taxed, there are certain situations where the settlement may be subject to taxes. These exceptions typically arise when the settlement is related to non-physical injury or if it involves compensation for lost wages or other taxable elements.
- Non-Physical Injury or Sickness
If the settlement is related to non-physical injuries (e.g., emotional distress, defamation, or discrimination claims), the settlement may be taxable. The IRS typically treats emotional distress as taxable unless it is directly tied to a physical injury or illness. In such cases, the emotional distress compensation is considered taxable income. - Lost Wages and Business Income
Compensation for lost wages or lost business profits is generally taxable, regardless of whether the injury is physical. The IRS treats these amounts as ordinary income, meaning they are subject to the same taxes as salary or business income. If the settlement includes an amount for lost wages, it may be subject to withholding taxes (such as federal income tax, Social Security, and Medicare). - Interest on the Settlement
Any interest earned on the settlement amount is typically taxable. For example, if the settlement involves a delayed payment and interest is accrued, that interest is considered taxable income and must be reported on the recipient’s tax return. - Medical Expenses Already Deducted
If a person has already deducted medical expenses related to the injury in a previous year and later receives a settlement to cover those expenses, the amount received for medical costs may be taxable. This is because the taxpayer benefited from a tax deduction for the medical expenses in the past, so the IRS considers it “income” when those costs are reimbursed.
Structured Settlements: Special Tax Rules
A structured settlement involves receiving the settlement in periodic payments over time, rather than in a lump sum. The tax treatment of structured settlements generally follows the same rules as lump-sum settlements. However, the periodic payments for physical injuries or sickness are not taxable as long as they are related to the injury.
On the other hand, if a structured settlement involves any non-physical injury or covers lost wages, those portions of the settlement may be taxable.
Reporting Your Settlement
It’s crucial to correctly report your settlement on your tax return, especially if part of the settlement is taxable. If you receive a personal injury settlement, the payer should provide you with a Form 1099 if any portion of the settlement is taxable. This form will detail the amount of taxable income and help you accurately report it on your tax return.
In the case of a non-taxable settlement, the taxpayer may not need to report the settlement as income. However, it is recommended to keep detailed records, including the settlement agreement and any medical bills or other documentation, to clarify the nature of the payment if questioned by the IRS.