After a long and arduous battle, you finally reach an agreement. You get the check as the compensation. And that nagging question – is personal injury settlement taxable?
Undeniably one of the most challenging times in life is when you face some kind of injury. The emotional and physical distress is becoming more unbearable. You are not able to focus on works, and your relationships have taken a backseat. To make things worse, your bills are increasing by the minute.
With very few exceptions, a personal injury settlement is not taxable in most of the states and regions. In any case, it is merely a compensation for loss, not gain. And you only pay your tax when you make gains. The money you receive as compensation for loss is not considered as a tip or salary. However, it is not as simple as that, and there are some exceptions. It depends on the type of injury and the type of case, and why the money was awarded.
The question of whether a physical injury settlement is taxable or not can be pretty confusing. Let us first study the types of personal injury compensations which can be divided into two main categories:
- General compensatory damages:These are the most common personal injury claims, which include physical pain, emotional distress, and loss of companionship.
- Special compensatory damages: Special compensatory damages are related to money and official records. These damages are related to physics injuries which may have caused pending bills, loss of a paycheck, or other costs such as medical expenses.
Cases like auto accidents, medical malpractice, industrial accidents, slip, and fall are compensatory damages that are not taxable.
There is another type of damage known as punitive damages. They are also known as exemplary damage and are taxable. It is additional damage awarded to a plaintiff. Cambridge Dictionary defines punitive damage as an amount of money that someone who commits a crime has to pay, that is intended to be large enough to prevent them or others from committing similar crimes in the future. Punitive damage is never intended to compensate the plaintiff in any way.
Difference between compensatory and punitive damage.
Compensatory damages are awarded to the plaintiff to compensate for the economic loss suffered due to the defendant’s actions. While punitive damages are awarded to the plaintiff to teach the defendant a lesson.
For example, Dean was texting while driving, all of a sudden he crashed into the rear end of Roy’s car which had stopped to allow the children to cross the road. Roy suffered a serious injury, while Dean tried to convince the police that it was Roy who stepped out of nowhere. Roy filed a case, and they went to court. At court, it was determined that Dean was at fault. Dean paid $8000 compensation fees to Roy including medical fees and car expenses. The judge also pointed out that it is illegal to use a cell phone while driving, and ordered Dean to pay an additional $10000 as punitive damage.
There are several guidelines laid by the Internal Revenue Service or IRS. Let us take a look.
A personal injury settlement may or may not be taxable. According to the IRS, you are excluded from paying taxes on the following grounds. The IRS terms it as ‘observable bodily harm‘.
- Personal injuries
- Lost wages resulting from physical injuries
- If a personal injury caused you emotional distress
- It must be understood that emotional distress alone is not considered a physical injury. The IRS will tax non-personal injuries award as income
- Physical injuries or psychological injury settlements were mostly free from tax up until 1966. Till today, most of them are not taxable. However, the laws are becoming restrictive
When and how is a physical injury settlement taxable?
As explained above, emotional distress settlement is taxable if it is not directly related to bodily injury
Here are two examples.
Tom injured his arm by a defective chainsaw. The chainsaw company paid $5000 compensation fees to Tom. And an additional $1000 for his mental anguish and emotional distress for living with pain and difficulties for several months. In this case, the personal injury settlement is a free tax. Tom does not have to pay a single cent as tax as it was observable bodily harm, and his emotional distress is directly related to physical injury. However, it will be taxable if Tom had a tax benefit in the previous years that relates to the case. That is if Tom deducted the cost of medical expense in the last year’s income tax return. In this case, the compensation will be considered as taxable.
Bobby’s restaurant suffered heavy losses because his neighbor told the people in the community that Bobby serves the meat of dead animals. Ultimately, a defamation lawsuit was sued against his neighbors. It was proved that the statements were false and Bobby settled with his neighbor for $10000. In this case, the settlement is taxable because though Bobby suffered monetary loss and emotional damage, there was no sign of a physical injury.
In case of a car accident, or related incident, the physical injury must be visible in the form of bruises, scrapes, cuts, broken bones, etc., to avoid the taxes. For example, Jerry’s car crashed into Tim’s car. Tim suffered a shoulder injury and was forced to stay at home for weeks. Not only did Tim suffer physical injury, but also suffered economic damage as well. Tim need not report the income, as it was a direct result of the injury. In short, it is a free cash Tim gets to keep.
If you earn an interest of any kind with the money you got from your personal injury case, it is taxable. Buying an investment, or interest money in your bank account, for instance.
It is required by the IRS to pay taxes if the physical injury is of the non-visible category. These injuries include defamation, sexual harassment, and slander.
Other non-visible injuries those are tax-free
It may be challenging to make the people or the court see that you are suffering if you received non-visible injuries. Non- visible injuries mostly incur in a car accident. The problem with this type of injury is that people do not see your wounds, and it can be a tough one convincing the court that you are in excruciating pain.
- Internal damage – Accidents can cause non-visible injuries like internal injuries to include, ruptured spleen, or bruised internal organs.
- Whiplash – It can occur when your car is hit from the rear. Your head is jerked or thrown backward and then forward violently.
- Traumatic Brain Injury (TBI) – You may suffer TBI without incurring visible head damage. TBI can affect both your short term and long term memory.
- Psychological injury – It includes anxiety, depression, and post-traumatic stress disorders.
All of the above are non -visible injuries, and your doctor knows you are hurt. But this may not be the case with other law enforcers in the court. This is why you need the help of an experienced personal injury attorney. The law provides that if physical injury or physical sickness is the origin of the claim, then it is not taxable. However, punitive damages are not to be included as they are always taxable.