People often wonder whether or not their personal injury settlement is considered taxable income. It’s a great question and a very real consideration for any case. Fortunately, the IRS has given us a fair amount of guidance on this topic. The most important aspect is that the IRS typically will not disturb a settlement that is “consistent with the substance of the settled claims.” This terminology basically means that the government will not alter a settlement so long as the parties are being truthful about the nature of it.
Let’s consider six different types of settlements:
Personal Physical Injuries or Sickness: If a person receives a settlement for a personal injury case, such as an automobile accident, and the settlement is a lump sum payment i.e. there is not a specific breakdown of the settlement distribution, then the full amount is not taxable. A person does not need to include the settlement proceeds in his or her income. As a practical matter, a personal injury attorney will typically request that the settlement in this form. Interestingly though, if a settlement is broken down, i.e. “X” for medical bills, “Y” for pain and suffering, and “Z” for lost income, then the IRS may tax the settlement. A person will be required to report it on Line 21 of Form 1040 as “Other Income.”
Building on this topic, settlements oftentimes contemplate Emotional Distress and Mental Anguish. This type of settlement typically is not taxable, but again, the IRS has a few exceptions. The main exception is non-physical injury or physical sickness, i.e. a person was not physically harmed in the case. Those amounts are included as taxable income. A person can, however, reduce this amount by any payments made for medical expenses attributable to emotional distress and previous deductions for medical expenses that did not give a tax benefit. Again, those portions would be reported as “Other Income.”
Lost Wages or Lost Profits: A person may miss time from work. This situation usually arises in the context of an employment related case, such as discrimination based race, religion, or national origin. Those proceeds are taxable. Additionally, that part of the settlement is subject to employment tax withholding by the employer. The employee needs to report those proceeds as “Wages, Salaries, Tips etc.” on Line 7 of Form 1040. Another situation is lost profits from a person’s business. That portion of the settlement is again subject to self-employment taxes. The IRS has offered guidance on it in Publication 334.
Loss-in-Value of Property: Quite simply, if a settlement is less than the value of the property, then it generally does not need to be reported on a person’s tax return. In rare circumstances, a property settlement is more than the value of the property. If it’s the case, then a person is required reported as a capital gain under Schedule D of Form 1040.
There are a few other areas that will occasionally come into play: Interest and Punitive Damages. Interest on a settlement is generally taxable obviously as “Interest Income.” It’s reported on Line 8 of Form 1080. Punitive damages, which are generally designed to punish or deter conduct, are also taxable income even if the punitive damages arose from a personal injury case. Much like the other areas, punitive damages are reported as “Other Income” on Line 21 of Form 1040
We hope this synopsis of settlements and taxability is helpful to you. If you would like more information on this topic or have any additional questions, then please feel free to contact me at kevin@patricktriallaw or 404-566-8964.