When you get into an accident or get injured through someone else’s negligence, you can (and should) obtain a personal injury lawyer and file a claim for the damages you suffered. These cases resolve with a settlement agreement out of court a verdict awarded by a jury in a trial or, in rare cases, by a judge.
Your compensation after a hard-fought legal battle can be instrumental in helping you heal physically, mentally, and financially. However, it is essential to consider the tax implications of such an award.
Thankfully, the IRS can’t tax your entire award. But to minimize the effect federal and state taxes will have on your verdict or settlement, we must first break down the types of damages you received—and what this means for your taxes come April.
Types of Damages in a Personal Injury Lawsuit
Most personal injury verdicts and settlements are made up of one or more of the following types of damages:
- Coverage for your medical bills,
- Pain and suffering damages,
- Loss of consortium damages for the injured party’s loved ones,
- Compensation for property damaged in the accident,
- Income lost due to being unable to work after your injury, and/or
- Punitive damages meant to punish the party at fault.
Generally speaking, compensation meant to “make a victim whole” after their injury is considered non-taxable income by the IRS. In other words, any compensation associated with a physical injury—medical bills, pain and suffering, property damage, and other compensation—can’t be taxed.
But, as is usually the case with the IRS, there are exceptions. We’ll break them down below:
According to Publication 4345 from the IRS, your settlement or verdict amount allocated for “personal physical injuries or physical sickness” is not taxable. It should be excluded from your income when you file. This includes prescriptions, doctor visits, hospital bills, or long-term treatment from specialists, such as chiropractic care or physical therapy.
However, if you suffered an injury in a previous year, you may have written off your medical expenses by itemizing deductions on an earlier tax return. According to the IRS, any portion of your award meant to cover the costs you wrote off must be reported as income this year. IRS Publication 525 includes more details on how to do this.
Pain and Suffering
Just as compensation for physical injuries is not taxable, any compensation for emotional harm stemming from your bodily injury is generally non-taxable. In the eyes of the IRS, the costs of psychiatric care, therapy, or prescriptions are lumped in with your medical bills.
Unfortunately, there are exceptions to this rule. The key phrase that makes emotional distress damages non-taxable is “stemming from your physical injury.” If you suffer emotional trauma from your accident that is not associated with a physical injury, you may need to include any compensation you receive in your income. You can reduce the amount you report to the IRS by deducting any expenses you incurred in seeking care for your emotional injuries.
Loss of Consortium
Loss of consortium damages are awarded to the close family members (often a spouse, parent, or child) of an injured victim for any emotional injuries they suffered by losing the companionship of their loved one. Like pain and suffering damages, loss of consortium damages are non-taxable provided they are related to their loved one’s physical injury.
Any compensation you receive for property damage is generally not taxable, provided that your award does not exceed the “adjusted basis of your property” (that is, the current market value of your property). If your award exceeds the property value lost, the excess compensation is taxable as income.
For example, say you were involved in a severe car crash. If your car was valued at $18,000 before the crash and you received $25,000 in compensation, you’d owe taxes on $7000. This amount would be taxed as income by the IRS and the State of California.
The IRS clearly states in Publication 4345 that the portion of any settlement or verdict in an employment-related lawsuit allocated for lost wages is taxable. Had you normally earned the wages you lost, your taxes would have been deducted from your paycheck—so paying taxes on your back pay award is expected.
However, the law is muddier concerning taxes on income lost due to a personal injury. IRC § 104(a)(2) states that “the amount of any damages (other than punitive damages) received on account of personal physical injuries or physical sickness” is considered non-taxable income.
Many courts have held that back pay is not awarded to a victim “on account of” any personal injury, and is therefore considered taxable income. Their logic is that you would have earned and paid taxes on the wages awarded as back pay had you not been injured, and your injury did not increase or decrease the amount of back pay you received. (C.I.R. v. Schleier, 515 U.S. 323 (1995))
Despite this, most personal injury awards do not distinguish between the types of compensation awarded to the victim. It can be difficult for the IRS to determine which, if any, parts of a personal injury result should be taxed.
Speaking with a tax professional is the best way to know for sure whether or not a portion of your award is taxable.
The previous types of damages on this list are called “compensatory” damages, intended to compensate the plaintiff for the defendant’s misconduct. On the other hand, punitive damages are meant to punish the defendant for particularly egregious conduct.
Because these damages are not intended to “make you whole,” punitive damages are taxable as income by both the IRS and the State of California. However, punitive damages are rarely awarded in personal injury cases, so it is unlikely you will face this issue.
Get Answers About Your Result
Tax laws are confusing and ever-changing, and it’s difficult to consider taxes on an outcome meant to restore your life. To ensure you aren’t taxed a cent more than necessary, it’s important to discuss your settlement or verdict amount with a trusted tax advisor. A tax specialist will be able to answer any form-specific questions you have.
After a car accident, our firm is available 24/7 to help you through your recovery process. Contact us today.