Generally a personal injury settlement or verdict is not taxable. Personal injury settlements are usually exempted from Federal and State taxes. IRS Publication 4345 states that settlements received for personal physical injuries are not considered to be income for the taxation purposes. The objective in any personal injury case is to make the injured party whole. As the result of being in an accident, the injured party usually suffers medical expenses, lost wages, along with pain and suffering. The settlement or verdict is designed to compensate that injured party for those collective losses, in an effort to make the claimant whole. A monetary settlement alone will likely not heal wounds, ease pain, or erase the hardship caused by an accident. But, the law views that settlement or verdict as making the injured party whole again. As a result of returning the claimant to being whole the settlement or verdict is not subject to being taxed. Even if the settlement includes a portion for lost wages it still remains non-taxable, even if the wages would have taxed if they were earned through employment. The compensation paid in settlement is not considered income because it merely replaces what was lost in the accident.
But, like most legal topics, there are exceptions to this rule that make some personal injury settlements taxable. First, punitive damages are taxable. Punitive damages are designed to punish the defendant for his egregious or outrageous conduct. The settlement would then presumably exceed the amount necessary to make the claimant whole. As a result, punitive damages would be considered income and therefore taxable.
A second, narrower exception to the taxability of personal injury settlements relates to medical expenses. If the claimant itemizes his tax return and deducted medical expenses, the deducted portion is subject to being taxed, assuming that the deductions provided a tax benefit to the claimant
Third, any interest or appreciation that the claimant receives as a result of a personal injury settlement is subject to being taxed. For instance, if the claimant places her settlement funds into an interest-bearing bank account, then the interest on the settlement funds would be taxable. However, the underlying settlement itself would not be taxable.
Another exception to the taxability of a personal injury settlement relates to losses sustained solely for emotional damage. The claimant would pay taxes on the proceeds that he or she receives relating to the settlement or verdict. This exception is narrow. Should the claimant show minimal physical injury and significant emotional injury that settlement would not be taxable.
Additionally, although the attorney will likely charge legal fees to prosecute the case, legal fees unfortunately cannot be deducted. Taxation issues can be tricky. Should you have any questions about the taxability of personal injury settlements or verdicts, please be sure to reach out to Burnett & Williams, P.C.