There are tax implications for those who receive a personal injury settlement, but is all settlement money taxable? The short answer: It depends. The tax treatment of personal injury settlements depends on the nature of the damages. Understanding the differences between these can help injured parties keep more of their settlement, and avoid surprises when tax season rolls around. This article will break down personal injury settlement taxation in a way that’s easy to understand while providing details needed to make informed decisions. Consult with our personal injury law firm in Ocala should there remain questions about a settlement. We also recommend consulting with a qualified tax professional to fully understand the implications of settlement taxation.

What Are Personal Injury Settlements?

A personal injury settlement is an agreement between a person who has been injured and the party responsible for the injury (often their insurance company) to resolve a legal claim without going to trial. In a personal injury case, the injured person (the plaintiff) seeks compensation for damages, which can include medical expenses, lost wages, pain and suffering, and other losses resulting from the injury.

The settlement amount is typically negotiated by the plaintiff’s attorney and the defendant’s insurance company, though the parties can also come to an agreement outside of court. If a settlement is reached, the defendant (or their insurer) agrees to pay a specified amount of money to the injured party. This is in exchange for the injured party agreeing not to hold the defendant responsible for the injury any longer.

Settlements are preferred for many because they offer a quicker, less expensive, and less risky resolution compared to a trial. However, it’s important to note that once a settlement is agreed upon, it generally means the plaintiff cannot pursue further legal action against the defendant for the same injury. This is why we recommend carefully assessing the terms of any settlement with a personal injury lawyer, to make sure fair compensation for an injury is received.

Settlement Taxation From a Personal Injury Lawyer

The Internal Revenue Code (IRC) defines what is considered taxable income in the U.S, and whether or not proceeds from a settlement are taxable depends on what the settlement is for and how it’s allocated. Under IRC Section 61, all income from any source is generally considered taxable, unless specifically excluded by another law. Settlements and awards from lawsuits are no exception.

That noted, IRC Section 104(a)(2) provides an important exclusion surrounding these laws. This section states that damages received for personal physical injuries or physical sickness are generally not considered taxable income. This means that if compensation is received because of a physical injury, those amounts are likely exempt from federal taxes, provided they meet certain conditions.

Breaking Down the Types of Damages

Personal injury settlements can also include different types of compensation. Each type has varying tax implications, including:

1. Compensatory Damages for Physical Injuries: These damages are meant to make one “whole” again by covering losses like medical bills and pain and suffering directly tied to a physical injury.

Tax Treatment: Non-taxable under IRC Section 104(a)(2). For example, if a person breaks a leg in a car accident and receives $50,000 for medical expenses, that amount is generally tax-free.

2.  Emotional Distress: These damages address the psychological impact caused by an injury or other harmful events. Emotional damages can be more complex, as their tax treatment depends on whether they are connected to a physical injury.

Tax Treatment: Emotional distress damages related to a physical injury (such as anxiety due to chronic pain from an accident) are generally non-taxable. Emotional distress unrelated to a physical injury (for example, caused by defamation) is generally taxable, unless it reimburses medical expenses that were not previously deducted.

3. Punitive Damages: Punitive damages are awarded to punish the defendant for particularly reckless or malicious behavior, not to compensate the injured for their loss.

Tax Treatment: Always taxable, regardless of the nature of the underlying injury.

4. Lost Wages: Lost wages are compensation for income the injured person would have earned if not for the injury. This is typically meant to cover the loss of earning capacity during recovery.

Tax Treatment: Compensation for wages lost is typically excluded from taxes if tied to a physical injury. However, lost wages awarded in employment-related lawsuits (like wrongful termination) are taxable as ordinary income.

5. Wrongful Death Claims: In wrongful death cases, the damages awarded are typically intended to compensate the deceased person’s family for their loss.

Tax Treatment: In some states, wrongful death damages may include punitive damages. If state law specifies that only punitive damages can be awarded for wrongful death, these amounts may be excluded from taxation under certain conditions.

Why the “Physical” Distinction Matters

Before 1996, damages for both physical and non-physical injuries were excluded from taxable income. The Small Business Job Protection Act of 1996 changed this by requiring that injuries be “physical” to qualify for the tax exclusion. As a result:

  • Emotional distress damages are taxable unless directly linked to a physical injury.
  • Damages for non-physical injuries, such as defamation or discrimination, are generally taxable. 
  • Damages for lost wages, benefits, or business income are taxable because they are not tied to physical injuries.

Documenting all details of both the damages and injury starting from the date of an accident will help the personal injury lawyer secure the best possible settlement for the injured party, and help determine if the settlement is taxable.

Key Takeaways

Working with a personal injury lawyer experienced in similar cases is highly recommended. Here are key takeaways as we wrap up some basics of personal injury settlement taxation:

  • Settlements for physical injuries or illnesses are usually tax-free, but there are exceptions for previously deducted medical expenses.
  • Settlements for emotional distress, lost wages, or punitive damages are typically taxable.
  • Always check how the settlement is allocated and keep detailed records for a tax return.

When in doubt, consult an attorney so that the settlement is properly structured and reported. For those looking for Ocala personal injury lawyers, we aim to arrange settlements that provide more of what is deserved: peace of mind.

Tips for Navigating Settlement Taxation

First, the settlement agreement should clearly outline how payments are allocated across different types of damages, such as physical injuries or emotional distress. This helps prevent confusion with the IRS. It’s also beneficial to work with a personal injury lawyer and tax advisor to structure the settlement in a way that increases compensation and maintains compliance with reporting requirements. Lastly, keeping detailed records of all expenses, including medical bills and lost wages, can support the claim for non-taxable compensation.

Your Personal Injury Law Firm in Ocala

The taxability of personal injury settlements depends on the type of compensation and the nature of the claim. While most damages for physical injuries are tax-free, awards for emotional distress, punitive damages, and non-physical injuries may be taxable. When in doubt, consult our personal injury law firm in Ocala to be sure your settlement is properly structured. Note that a tax advisor will assist with proper reporting. Knowledge is power, and being informed about the tax implications of your settlement can help maximize recovery and minimize unnecessary tax burdens.

Disclaimer: The information provided here is for general informational purposes only and should not be construed as tax advice. Tax laws and regulations are subject to change, and their application can vary based on individual circumstances. We strongly recommend consulting with a qualified tax professional to fully understand the tax requirements of any settlement or award. Additionally, you can contact our personal injury lawyers should you have further questions about your settlement.