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Tax Implications of Personal Injury Settlements

If you are pursuing compensation in a personal injury claim, it’s natural to wonder about your tax liability. The good news is that the Internal Revenue Service (IRS) typically considers settlements arising from physical injuries tax-exempt. Damages for non-physical injuries, such as emotional distress, humiliation, and defamation that result from physical injury, are also tax-free.

Tax & Settlements.

However, tax law can be complicated, and there are some potential exceptions to consider. Punitive damages, confidentiality settlements, and expenses deducted in previous years could be taxable income. To better understand the tax implications of your personal injury settlement, talk to a qualified and experienced personal injury lawyer.

Let’s explore tax exemptions and liabilities by breaking down a personal injury settlement and analyzing its potential tax implications.

The Components of a Personal Injury Settlement

Personal injury settlements can vary significantly depending on the circumstances of your case. However, typically, they comprise two main parts: (1) economic, or special compensation, and (2) non-economic, or general compensation.

Economic compensation

This portion of a personal injury settlement compensates you for your actual financial losses and is typically made up of three main components:

  1. Medical expenses: All medical costs directly arising from your accident, including hospital stays, surgeries, medications, diagnostics, and therapies
  1. Lost wages: Income lost as a direct result of getting injured
  1. Property damage: Compensates you for the cost of repairing or replacing property damaged in your accident

Non-economic compensation

This is typically a lump sum compensating you for the losses on which it is difficult to put a dollar figure.

These losses may include:

  • Pain and suffering: Physical and emotional distress arising directly from a physical injury or the wrongful death of a loved one
  • Humiliation or defamation: May be awarded if the accident or injuries have caused humiliation or damage to a person’s reputation
  • Loss of consortium: Reflects the impact the physical injuries have had on the victim’s marital relationship

Federal Tax Liabilities and Exemptions

The IRS typically does not tax the bulk of a personal injury settlement. However, it’s important to seek qualified advice to understand the potential tax implications of certain elements of the settlement.

Economic losses

Medical expenses directly related to treating physical injuries or illnesses arising from your accident are generally tax-free. However, be careful if you previously deducted any medical expenses for which you have now been compensated on a previous tax return. This part of your compensation for medical bills would be subject to federal taxes.

Lost wages are also tax-exempt in personal injury cases. This is true even though they are provided to compensate you for earnings that would otherwise have been taxed. However, lost earnings in other civil cases, such as employment-related lawsuits, are taxable income and subject to Social Security and Medicare tax rates.

Property damage compensation is tax-exempt if it is less than the adjusted basis of the property. Simply put, if you do not make a gain, this is not a taxable portion of your settlement. However, if you make a gain, you will have to pay tax on the surplus.

Non-economic losses

Non-economic losses are also generally tax-exempt, with some important caveats.

Pain and suffering compensation resulting from physical injuries or sickness are tax-exempt. However, if this compensation is awarded for purely emotional injuries that do not arise from physical illnesses or injuries, it is not tax-exempt. At the same time, the IRS allows you to reduce the compensation by the amounts paid for medical costs related to emotional distress that were either not previously deducted or deducted but without a tax benefit.

Humiliation and defamation compensation is also tax-exempt if it relates to a personal physical injury or illness. If it does not arise from physical harm, it may be taxable. For example, dog bite victims who receive non-economic compensation would be tax-exempt, as their distress and humiliation relate to a physical injury. However, if a dog chased you, causing emotional injuries, but did not cause a physical injury, your compensation would be taxable.

Loss of consortium compensation that was awarded on the basis of a physical injury or physical sickness that was caused by another person’s wrongful acts would not be taxed.

Punitive damages

Punitive damages can only be awarded in personal injury lawsuits as they are not components of out-of-court settlements. A court may award punitive damages to discourage a defendant who has committed particularly egregious acts from committing similar wrongful acts.

These damages differ from other forms of compensation, which are designed to make a person whole again after suffering losses. Therefore, the IRS considers punitive damages to be taxable; they must be reported as “Other Income” on line 8z of Form 1040, Schedule 1.

Interest

If your personal injury settlement includes interest payments, these would be considered taxable income. This should be reported to the IRS on Form 1040, US Individual Income Tax Return, line 2b.

The key phrases that run through the Internal Revenue Code (IRC) are “physical injuries” and “physical sickness.” Although all compensation awarded due to these two criteria is generally tax-exempt, it pays to get up-to-date advice from a tax attorney so that you can meet your tax obligations in full after receiving a personal injury settlement.

State Tax Rules on Personal Injury Settlements

Some states levy separate income taxes in addition to those charged at the federal level. For example, in 2023, Massachusetts levied a 5 percent tax on all income for state residents, while New Hampshire only charged income tax on certain types of income.

However, Massachusetts and New Hampshire follow the same rules as the IRS for personal injury settlements. Therefore, most personal injury settlements should be tax-exempt, with the exception of the situations mentioned above.

The Tax Implications of Confidentiality Clauses

Some personal injury settlements include a confidentiality clause. This prevents those related to the case from discussing the settlement. This may be because one or both parties want the settlement amount to remain confidential or need to avoid the reputational damage that could come from discussing the facts of the case.

Potentially taxable income

However, the IRS generally only qualifies settlements for physical injuries and certain non-physical injuries as exempt from federal employment taxes. Therefore, you could be liable for federal income tax on the portion of the settlement related to confidentiality.

A case involving Dennis Rodman brought confidentiality clauses into the public eye. Rodman paid $200,000 in a settlement to a man he had kicked, but the plaintiff did not pay tax on this settlement. Later, the United States Tax Court said that $80,000 of the settlement was for confidentiality and was, therefore, taxable income.

Seek advice

The takeaway is that you should discuss this matter with an experienced Massachusetts personal injury lawyer before accepting the terms of your settlement. It’s important to understand the tax implications of personal injury settlements before signing on the dotted line, as it will affect the final value of your compensation.

Are Legal Fees Tax Deductible?

When you hire a personal injury lawyer, he or she will often work on a contingency basis. This means that you do not pay any fees until you win. When you receive your personal injury settlement, the law firm will deduct the fee you agreed on before starting your personal injury claim. This is usually a percentage of the total compensation.

In personal injury and wrongful death cases, attorney fees are not tax deductible. In the past, legal fees related to personal matters could be deducted as a “miscellaneous itemized deduction.” However, since the 2017 Tax Cuts and Jobs Act passed, legal fees can no longer be deducted.

Reporting Personal Injury Settlements to the IRS

IRC Section 61 defines gross income as “all income from whatever source derived.” This would include all elements of a personal injury settlement, whether they are tax-exempt or not.

However, please note that declaring income on your annual tax return does not always mean that you pay taxes on it. Tax regulations change frequently, so it is always best to seek up-to-date advice from a qualified tax professional before filing your annual return.

Maximize the Benefits of Your Personal Injury Settlement

Personal injury settlements are designed to make you whole again. To help you get back on your feet both physically and financially and face the future with confidence. The IRS and state tax legislation recognize this, which is why the taxable portion of a personal injury settlement for physical injuries or sickness is likely to be very small.

The team at Kiley Law Group is here to fight for your rights and help you get the maximum benefit from your personal injury settlement. This could include arranging periodic payments rather than a lump sum. We can also connect you with a tax professional to guide you through the tax implications of your settlement.

Now is the time to discuss your personal injury case with one of our compassionate and experienced attorneys. Schedule a free case evaluation with a Kiley Law Group personal injury lawyer by calling (978) 965-3228 or filling out our contact form today.