Settlements for personal injury lawsuits often involve damages that can
be roughly divided into two groups: economic damages and non-economic
damages. In this post, we will look at how the Internal Revenue Service
treats the tax status of the various “types” of damages that
may be awarded, or negotiated, in a personal injury lawsuit.
Many plaintiffs are unaware of their potential liability for taxes assessed
on portions of their personal injury lawsuits. In general terms, economic
damages (damages that have a “dollar value” that is relatively
easy to determine) are usually tax exempt. Examples of economic damages
that may be awarded in a personal injury accident lawsuit include:
- Costs of medical treatment for injuries received in an accident and anticipated
future medical expenses
- Replacement / repair of damaged personal property (e.g. an automobile or
- Lost wages due to an inability to work because of injuries received in
- Loss of anticipated future income in cases of catastrophic or fatal injuries
Economic damages are, as a rule, usually not considered as taxable income.
On the other hand, non-economic damages are “subjective” (based
on an individual’s “interpretation” or “impression”)
rather than based on “hard facts.” These damages may include:
- “Pain and suffering” due to the injury and its consequences
- Inability to participate in family activities
- In cases of catastrophic injury or death, loss of an individual’s
future contributions to family life in the form of advice, companionship,
“Punitive” or “exemplary” damages represent a special
category of non-economic damages that are intended to punish a defendant’s
negligence or other contribution to an accident. Non-economic damages
are usually considered to be taxable.
For many years, the Tax Code stated that the settlement of a lawsuit involving
a “personal injury” to the plaintiff was not taxable income.
Since the Tax Code read “personal injury” rather than “personal
physical injury,” both the administrative IRS tax courts and the
federal courts gradually “loosened” their interpretation of
what constituted a “personal injury” to include non-physical
injuries such damage to one’s personal or business reputation, emotional
distress, and even the inconvenience of filing a lawsuit. Under the previous
versions of the Tax Code, only “punitive” or “exemplary”
In 1996, Congress enacted a change to the wording of the tax code to mean
that only settlements, or parts of settlements, for a personal physical
injury are tax-exempt. In later decisions, the courts have ruled that
compensation for any condition that “flows from” (is a direct
consequence) of a physical injury is also tax exempt. As you might imagine,
proving that a condition is a direct consequence of an injury can be critical
in reducing the portion of a settlement that is subject to taxation.
How a Personal Injury Lawyer Can Assist Clients with Tax Issues
Many clients of personal injury lawyers are unaware that any settlement
that they receive can create a situation where they stand to lose a substantial
portion of any damages settlement to taxation. Furthermore, this tax liability
may “spill over” into subsequent years if a structured settlement
Although very few personal injury lawyers consider themselves to be tax
attorneys, practically all such lawyers are familiar with those portions
of the Tax Code that may affect personal injury lawsuit settlements. Should
an issue arise in an area where a personal injury attorney may be uncomfortable
regarding a point of tax law, he or she will have access to an attorney
whose practice includes tax law.
When preparing a personal case for trial a personal injury lawyer will
consult with experts to determine which of a client’s injuries are
“direct” injuries and which injuries are indirect yet “flow
from” those direct injuries. Since both direct injuries and injuries
that occur secondary to primary injuries are not considered to be taxable
income, expert opinions in these areas will justify higher awards that
are not considered to be taxable.
Finally, a personal injury lawyer may negotiate a structured settlement
agreement to reduce the “up front” tax liability. In such
a settlement, which is relatively common in catastrophic injuries involving
the brain or spinal cord that will require potentially expensive long
term care, the damage award is placed in a trust fund or a similar arrangement
where payments are made on an “as needed” basis for any expenses
incurred by the accident victim. Since such disbursements are only taxable
in the year that they are received, structured settlements van be effective
in reducing tax liability.
To wrap up this week’s post, we have seen that an accidental injury
settlement can cause taxation issues for the recipients of damage settlements.
Fortunately, personal injury lawyers are aware of these potential issues
and will work to insure that any damages awarded will benefit the accident
victim rather than fund the activities of politicians.