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Is My Accident Settlement Considered Taxable Income by the Internal Revenue Service?

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.

The Problem

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 a motorcycle)
  • Lost wages due to an inability to work because of injuries received in an accident
  • 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, and earnings

“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.

The Law

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” were taxable.

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 is involved.

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.

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