Are Personal Injury Settlements Taxable? A Comprehensive Guide
Personal injury settlements offer much-needed financial and mental relief to the sufferer. However, many people are confused about the taxation process of personal injury claims. So, are personal injury settlements taxable? Also, does the same rule apply to all the states?
The taxation policy of personal injury settlements is quite complex. Generally, compensation payouts for physical injuries resulting from accidents, falls, and slips, among other causes, are tax-free. According to the IRS, your compensation for medical expenses, emotional distress, and pain and suffering is generally non-taxable.
However, payouts for punitive damages, indirect mental stress, and lost wages could be taxable. Therefore, you must thoroughly understand the taxation policy for personal injury.
Are Personal Injury Settlements Taxable?: The General Rule
IRC Section 104(a)(2) provides significant relief for individuals receiving personal injury settlements. It excludes from gross income “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”
The key phrase here is “personal physical injuries or physical sickness.”
It determines both the taxable and non-taxable personal injury claims. The section has different explanations and exceptions that determine the taxability of the injury payouts. The Internal Revenue Service does not consider the compensation for direct physical harm taxable.
The IRS draws a clear line:
“Physical injury is the prerequisite for tax-free emotional distress compensation.”
Non-taxable payouts include:
- Medical Expenses: All past, present, and future medical bills are tax-free. It includes doctor visits, hospital stays, medication, and surgeries. The expense needs to be directly related to the injury.
- Pain and Suffering: If you receive any payout or award for physical pain, discomfort, and emotional distress, it’s also tax-free. However, the pain and suffering must be the direct result of the bodily injury.
- Emotional Distress: Generally, compensation for emotional distress could be taxable. However, it has an exception related to personal injuries. You get tax-exemption for emotional distress directly linked to the personal injury. For instance, you can face anxiety or depression after a car or physical accident. So, the compensation for this depression would likely be non-taxable.
- Lost Wages/Income: Sometimes, people may be permanently or temporarily unable to work or earn an income after an accident. You receive tax exemption for such inability-related payouts. For instance, you may need to leave your job temporarily due to a broken bone after an accident. So, you will get a non-taxable compensation for lost wages.
- Loss of Consortium: A spouse could lose companionship, affection, and support due to the injured party’s physical condition. Therefore, the award to the spouse in such a condition is not taxable.
- Rehabilitation Costs: Do you need physical therapy, occupational therapy, or other rehabilitation services? The payout for such rehabilitation costs is tax-free.
When Are Personal Injury Settlements Taxable by the IRS (Exceptions)?
The Internal Revenue Service (IRS) considers personal injury settlements in some exceptional cases. The top personal injury attorneys in California mentioned that settlements for punitive damages are taxable.
Also, if your emotional distress or mental anguish isn’t a direct product of the physical injury, plus, sometimes your lost wages might not be directly linked with physical inability due to accidents. In such cases, you will have to pay taxes on the compensation.
Punitive Damages:
Punitive damages are always taxable. It is the most straightforward exception to tax-free payouts for personal injuries.
Punitive damages are meant to punish the wrongdoer for egregious conduct. It aims to deter the wrongdoer from similar actions in the future. When the court announces the punitive damages, a portion of it is awarded to the claimant.
So, the award for punitive damages is not intended to compensate for a loss. That’s why it is fully subject to federal income tax. The tax is applicable even if you have a physical injury due to the accident.
Emotional Distress and Lost Wages (Without Physical Injury):
Emotional distress and lost wages are two of the most confusing parts of the taxability of compensation due to personal injuries. We have already mentioned that you get a tax exemption if the emotional distress and lost wages are a direct result of your physical injury.
However, sometimes, you might not have any visible physical injury. Also, your mental anguish and loss of income opportunity could occur without any bodily injury. In such cases, you will have to pay taxes on the received award.
Thus, your non-physical injury disputes are treated as taxable income. It is similar to regular wages.
Interest on Settlements:
If you earn any interest on the settlement, it’s taxable. The duration will be from the date of your injury until you receive the payment. The IRS considers interest in a settlement as regular income, and therefore, it is taxable.
Medical Expense Deductions Taken in Prior Years:
Many times, injured people might have deducted their tax on medical expenses earlier. If they receive a settlement for a similar injury, it would likely be taxed. This occurs due to the “tax benefit rule.”
The tax benefit rule prevents people from receiving a tax deduction and then receiving tax-free compensation for the same expenses. The taxable amount would be similar to your prior deduction.
Are Personal Injury Settlements Taxable in California?
In the USA, different states apply various tax rules for personal injury settlements, including California. Are personal injury settlements taxable in California?
The straightforward answer is, yes:
“California generally follows the federal tax law for the exclusion of personal physical injury or sickness damages.”
So, if IRS rules have determined that any portion of the settlement is for non-physical injuries or sickness, it will typically also be non-taxable in California. At the same time, if the IRS taxes all or part of the settlement, the California authority will also tax it. It applies to punitive damages, interest earned on the settlement, or compensation for emotional distress in the absence of any physical injury.
Conclusion
Generally, your medical bills, lost wages, and emotional distress aren’t tax-free. The condition is that the reason must be personal injuries, and it must be direct as well. If your injury isn’t linked to direct physical injuries, it will most likely be taxed by the IRS.
You may want to consult a personal injury lawyer. They can assess your injuries and give a clear idea about your compensation amount. They will also answer whether the compensation is completely or partially taxable.
