When dealing with the aftermath of a personal injury settlement, tax issues may be the farthest thing from your mind. Nevertheless, it's important to be aware of the potential tax consequences that could occur as a result of your settlement or verdict.
Damages Awarded for Physical Injury are Non-Taxable
Determining whether or not a settlement or verdict is subject to federal and state taxes depends on whether the damages are treated as income or wages. According to the Internal Revenue Service (IRS), damages for personal physical injuries and illnesses are not considered income or wages. Therefore, you are not required to pay federal or state taxes on the settlement proceeds.
On the other hand, the settlement proceeds become taxable if it was meant to replace lost income. If you've claimed medical expenses in years prior to the settlement and later received reimbursement as a result, you'll have to report that amount as income.
Damages Awarded for Emotional Injury Alone are Subject to Taxation
Depending on the nature of your personal injury lawsuit, you may receive damages for emotional distress. If the emotional distress occurred as a result of physical injury or illness, then any damages received for emotional distress aren't taxable. Damages for emotional distress that leads to physical illness may not be subject to taxation, either.
However, damages awarded for emotional injury alone (where absolutely no physical injury occurred) may be treated as income and, as a consequence, become subject to taxation.
Other Taxable Damages
There are several other circumstances where you may be required to pay taxes on your settlement or verdict proceeds:
- Damages based on breach of contract – If your lawsuit is based on a breach of contract, even if said breach resulted in a personal injury, any damages awarded will be subject to taxation.
- Punitive damages – Even if you receive punitive damages as a part of a settlement or verdict for personal physical injury or illness, you are still required to report to proceeds as income. For tax purposes, personal injury verdicts are often separated into compensatory and punitive damages, since the former isn't taxable.
- Interest collected on the settlement amount – Interest collected on the proceeds of a settlement or verdict is taxable, as these earnings are usually considered a form of income. The settlement or verdict amount, however, remains untaxed.
It's always a good idea to speak to an attorney like Kenneth R Schuster And Associates PC when dealing with a personal injury settlement or verdict. They may even be able to refer you to a tax expert to help with calculating your personal injury taxes. After all, there may be exceptions or nuances to federal and state tax law that are easy to overlook.
