The taxability of personal injury settlements can be somewhat complex. Some portions of your personal injury settlement may be taxable, while other portions may not.
Below, we review some of the basic rules the IRS imposes for personal injury settlements. For more detailed information about how a settlement might affect your income taxes come filing time and how to plan appropriately to minimize your taxes, call Montero Law Center in Fort Lauderdale at 954-767-6500 today.
Are personal injury settlements taxable?
Taxation for settlements depends on the origin of the claim. Settlements for wrongful termination, breach of contract, and other non-physical injury cases are taxable. Fortunately for injured victims, personal injury claims are different. For the most part, the money you receive from a personal injury claim is not taxable under either state or federal law.
Damages you receive as a result of personal physical injuries or sickness are meant to reimburse you for your losses. This includes damages you receive for medical bills, back pay, emotional distress, and attorneys’ fees. The legal theory is that since you already paid for these losses once, you have already paid your fair share of taxes on them. Since they are not taxable, you do not have to include them as part of your gross income for the year when filing your taxes.
So long as the damages are to compensate you for losses stemming from a personal physical injury or sickness, the proceeds are nontaxable. “Generally, the IRS will not disturb an allocation if it is consistent with the substance of the settled claims,” explains the IRS in Publication 4345: Settlements – Taxability.
What types of damages from personal injury cases are taxable?
There are a couple exceptions to the above rule:
Prior deductions for medical expenses: If you took an itemized deduction on a previous tax year for medical expenses related to your personal injury or sickness, you must include the portion of your settlement allocated for those medical expenses as part of your income. This is because you already had a tax break for those expenses the year you claimed the deduction, and the IRS prohibits double-dipping.
You need to report the tax benefit amount as “Other Income” on line 21 of Form 1040.
Pain and suffering damages unrelated to a physical injury: As aforementioned, damages you receive for pain and suffering (e.g., emotional distress, mental anguish, etc.) that arose from a personal physical injury or illness are nontaxable. However, if your claim was for an emotional injury only and your pain and suffering damages did not originate from a physical injury, then you must include those damages as part of your income.
The IRS stipulates that the determining factor for taxability of a settlement is whether the injury was visible. To be tax-free, your damages must stem from injuries that are sufficiently physical.
Even still, the IRS allows you to reduce your tax on proceeds from emotional injury-only claims by deducting medical expenses such as mental health treatments and prescriptions for mental disorders you paid that were attributable to your emotional injuries.
Interest: In some cases, courts award pre- or post-judgment interest for verdicts claimants must wait to collect. Any interest you earn on your personal injury case proceeds is taxable. You must report it as “Interest Income” on line 8a of Form 1040.
Punitive damages: Florida law permits courts to grant punitive damages in cases involving gross negligence or intentional misconduct. Any awards you receive for punitive damages from your personal injury claim are taxable, even if you received the damages as part of a settlement for personal physical injuries.
Florida allows punitive damage awards of up to three times the amount of a victim’s compensatory damages. If your compensatory damages totaled $1 million and you received an additional $3 million in punitive damages, the $1 million would be nontaxable, but the $3 million would be fully taxable. The IRS will certainly love taking its cut of that.
How can I protect my injury settlement from taxes?
If a portion of your personal injury settlement is taxable or if you have two claims against the defendant (one taxable and one nontaxable), then your attorney at Montero Law Center can itemize the losses and damages in the claim. Carefully allocating the funds on paper prior to collecting the settlement will help protect your assets.
“Most legal disputes involve multiple issues…There’s a good chance the total settlement amount will involve several types of consideration. It is almost always best for plaintiff and defendant to try to agree on what is being paid and its tax treatment. Such agreements aren’t binding on the IRS or the courts in later tax disputes, but they are rarely ignored,” explains Forbes.
The IRS can challenge the taxability of a settlement if the agency so chooses. Allocating your assets will protect your nontaxable proceeds. Skipping this step and lumping it all together may entitle Uncle Sam to more than his fair share.
Let Montero Law Center help you maximize your injury settlement.
Our attorneys at Montero Law Center represent injured victims in Fort Lauderdale and the surrounding areas. We are committed to providing the quality of service our clients deserve and protecting their right to justice.
With over three decades of experience representing injured clients, we have developed tried-and-true strategies for maximizing our clients’ recoveries. We account for every loss on their claims and ensure that the insurer pays them what they deserve. If we cannot reach a fair settlement, we will take the case to court and fight for the full restitution the victim deserves.
Taxation rules are fraught with exceptions and nuances. Get legal advice to minimize your tax liability and avoid an audit. Your Montero Law Center attorney will also counsel you on important tax issues to consider regarding your personal injury case. He will take all the necessary steps to protect the proceeds and shield them from excess taxation.
For a free consultation with a personal injury attorney in Fort Lauderdale, call 954-767-6500 today.