One of the questions that we are asked as an attorney is do you have to pay taxes on insurance settlements.
Our clients want to plan after their insurance settlement, and they need to know how much money they may have to put aside from their accident settlement.
In addition, this would impact negotiations with the insurance company, because a tax liability may require that they negotiate more in their injury settlements.
The Elements of Your Personal Injury Settlement After an Auto Accident
When you receive an insurance settlement for or money for a jury verdict, it actually has a number of things for which you are being paid. Personal injury compensation takes on two primary forms. The first is economic damages.
These pay you back for money that directly came out of your pocket or that the injury prevented from going into your pocket.
Economic damages include:
- compensation for lost earnings (lost income both past and future)
- compensation for a reduction in your earnings power
- compensation for medical expenses (both in the past and the future medical bills)
- payment for property damage
Damages Relating to Physical Sickness
Then, you are also entitled to non-economic damages for your accident injuries. These are damages that relate to your physical injury or sickness.
As your personal injury attorney would explain, this would include the following elements of damages:
- pain and suffering
- emotional distress
- loss of enjoyment of life
- loss of reputation
- permanent disfigurement
In addition, there are also possible punitive damages (very rare), and these have their own special rules.
IRS Guidance About Personal Injury Settlements
Thankfully, you are not flying blind about whether settlements are taxable income. The IRS has some extensive guidance about what must be included in your tax return and whether you must pay tax.
However, like anything from the federal government, these rules can be complicated, and they are not always straightforward.
The IRS has the following publications that touch on the topic of what is considered income in your personal injury insurance settlement or award:
You may need advice from both a personal injury lawyer and an accountant if you receive a settlement as to what is taxable and what is non taxable.
Also, please consider the fact that the law is evolving and what may be considered compensation from a settlement may be considered income in the future as case law evolves.
Contact our attorneys today for a free case evaluation about how your settlements may be viewed by the taxing authorities.
Do You Have to Pay Taxes on Insurance Settlements
While the general answer to this question is no, it is not always as straightforward as that. As you saw above, personal injury settlements and awards have different line elements to them.
It all depends on what the compensation is for. Certain parts of your award may be taxable, while others are not. On balance, more of your award than not will not be taxable.
You may wish to consult with an income tax professional before signing any releases that relate to the settlement of a personal injury case to minimize your potential tax exposure.
How to Know What Is Tax Free
Before you agree to anything, you should know what portion of the settlement may be taxable. The last thing that you want is an unwanted surprise at tax time.
This would involve consultations with an attorney and an accountant. The value of any possible taxes should be factored in when you are negotiating with the insurance company.
Your attorney would be familiar with IRS guidance and should advise you before you sign the settlement agreement.
Special Rules for Medical Expenses
In most cases, the payments that one receives for medical expenses are completely tax-free. This makes perfect sense because this is not money received by the plaintiff. Instead, it is paid directly to medical providers who provide treatment.
According to the Internal Revenue Service, there is one way that you may need to pay back some of your medical expenses payment in tax.
If you decided to take an itemized deduction for medical expenses in a prior year (when your medical payments exceeded 7% of your adjusted gross income), you would need to pay this back to the government with your tax return.
You do not get to keep this tax deduction if you get a later settlement.
For example, if you are seriously injured in a car accident and will likely have ongoing medical expenses related to your injuries. These future medical expenses would likely not be taxable as part of a car accident settlement with an insurance company.
Property Damages Are Not Taxable
One of the aspects of the question of are settlements taxable is what happens to the money that you receive to pay for damage to your property, such as your car.
This makes sense because you are not receiving a windfall payment. Instead, you are just getting money back for something that was already yours that you lost. This is not treated as income on your part.
How Lost Wages Are Treated in Your Car Accident Settlement
Lost wages are a tricky part of your personal injury settlement after a car accident. The IRS Tax Code actually helps personal injury claimants here. 26 USC 104 excludes from the definition of “gross income” any payment that was awarded on the basis of a physical injury.
As a result, the IRS will use the “origin of the claim” test. If you file for lost wages because of employment discrimination, that would be considered taxable income.
However, if you cannot work because of injuries that you suffered in a car accident, this is a payment that you receive because of your physical injuries. Therefore, the lost wages part of a car accident settlement would not be taxable.
You can have different treatments of lost wages in the same settlement. Not all of your lost wages may be attributable to your physical injury. The part that is not may be taxable.
The Tax Status of Pain and Suffering
Your non-economic damages are also part of your injury settlement. This is payment for what you have gone through and continue to experience.
By no means is this any kind of economic windfall. Those who are suffering from post-accident anxiety and physical pain can testify to that.
Pain and suffering damages compensate you for the difficulties caused in your life. These are also not subject to any kind of income tax on the federal level.
How Are Attorney Fees Treated?
There is a question about the amount on which you must pay taxes. Your attorney works on a contingency basis in a personal injury case. They will take a percentage of your total recovery as payment for their services.
This is an issue if your case results in a large award of punitive damages. You may need to pay taxes on the entire amount of the punitive damages award, including the amount that is paid to your attorney.
This is something that you need to plan for at tax time if you have received a large jury verdict.
The same thing applies if you have received a settlement, and there is part of that settlement that is taxable.
Punitive Damages Are Taxable
Punitive damages are one of the ways that you may receive money in a lawsuit. However, this does not come in the form of a settlement agreement because the defendant (and insurance companies) never agree to pay these damages.
They are awarded by the jury to punish very bad conduct on the part of the defendant. They are very rare, and they are only meant to reach some of the most extreme examples of negligence and recklessness.
These are the types of damages that could greatly magnify your award. When you see jury verdicts for eight and nine figures, chances are that they include punitive damages. This form of compensation is taxable. The reason why is that this is thought of as a monetary reward for the plaintiff, even though its prime purpose is to punish the defendant.
Accident victims would report this as “other income” on their income tax returns.
Emotional Distress Awards Can Be Taxable
One of the non-economic damages that a claimant is entitled to is emotional distress. This compensates them for some psychological injuries suffered from a personal injury.
The Internal Revenue Service (IRS) has special rules about how this type of injury is treated.
If your emotional distress originates from physical injuries, tax law treats it the same as the physical injury itself. This part of your claim would not be taxable.
However, there is a different rule when the emotional distress itself is your injury. Then, your payment is taxed, minus the amount that you spent for medical bills related to the injury.
Will I Need to Pay State Taxes?
The same laws that apply on a federal level also apply to state taxes. You will not need to pay state income taxes on the injury part of your personal injury settlement.
The rule of thumb is that you would need to pay the State of Illinois on the same amount of income as you would the IRS. You would list your federal adjusted gross income on your state tax return.
This means that you would owe money on things like punitive damages and emotional distress. Do not lose sight of this when you are trying to decide on the appropriate amount of lost wages in your settlement agreement.
You Can Try to Be Proactive When Settling Your Claim
Parties may try to structure their settlement agreement to maximize line items that are not treated as taxable income to keep as much money in their pocket as possible.
This means that the agreement would maximize things like pain and suffering at the expense of taxable line items such as lost wages. Our best advice is caution. At the end of the day, the IRS is not bound by the terms of your settlement agreement.
They may have a different opinion of what is taxable, and that is what controls your situation, regardless of your intent.
Always consult with an attorney and tax professional for advice. You can try to save on taxes based on how you allocate the individual line items of damages.
The Language of the Settlement Agreement Matters
If there are any questions about whether something is taxable, the U.S. Tax Court will look at the exact language used as a measure of the parties’ intent when entering the settlement agreement.
This means that your attorney will need to carefully review all of the provisions of the agreement before you sign it.
Otherwise, loose language or sloppy drafting could create a situation where you end up with a tax bill because someone did not pay attention to what you are signing.
Personal Injury Attorneys Helping Clients
To learn more about recovering financially for your accident injury and whether settlements are subject to taxes, contact the attorneys at Rosenfeld Injury Lawyers today. We will talk to you at your free consultation and learn more about your case.
We will then investigate your injury and help you prepare for the claims process. Our lawyers will work hard for you on your personal injury case, fighting to protect your legal rights and maximize your settlement.
We are a full-service law firm. We will not simply tell you to talk to a tax lawyer when these issues come up in your settlement. Instead, we will work with you to get you the advice that you need.
Many of our current and past cases involve auto accidents such as a car accident, trucking accident, motorcycle crash or pedestrian injury. We also handle complex litigation involving medical malpractice, nursing home negligence, sexual abuse and medical device litigation.
Our law firm is your guide when you have an injury law matter and want to know whether your settlement is taxable. Call us for a free case evaluation.