Personal Injury Settlements And Taxes: What You Should Know

It feels really good to finally settle a personal injury lawsuit, until you have to figure out the taxes. If you've recently settled a personal injury lawsuit, or are about to, here's what you should know about the taxes.

The Law Changed Significantly In The Last Decade

Under old rules, just about any money associated with your personal injury claim wasn't taxable, and many people think that it still true. However, in 1996, the IRS rules changed. Now, many awards are at least partially taxable as either wages (which means additional FICA taxes) or other income (which doesn't). It's important to separate the amounts, so that each section is taxed at the appropriate rate.

What's Taxable 

Looking at the bad news first, here's what you can expect to be taxable, and how:

• any punitive damages, which should always be separated from compensatory damages and listed as "other income" on your taxes.
• compensation for emotional damages only, where there was no physical injury or illness related to it are "other income" for the IRS.
• any interest on the judgement - which is often retroactively awarded and calculated back to the time the case was first filed - must be listed as "interest Income" on your taxes.
• any part of your compensation that's for medical expenses which you've already used as a deduction in a prior year, which is considered "other income" by the IRS.
• money from an employment-related lawsuit, like an employment discrimination claim, is taxable as "wages" by the IRS if it is for past or future lost wages.
• compensation where the lawsuit relates to damages to your business or self-employment is treated as "business income" for tax purposes.

You also have to report the full amount of the award on your taxes, before attorney fees. Attorney fees for any part of the taxable award can be listed as an itemized deduction elsewhere in your taxes.

What Isn't Taxable

The good news is that any compensation that you receive related to a physical injury or physical illness is not taxable. That includes damages for the pain and suffering, emotional damage, mental anguish, and (in an unusual quirk) money for lost wages in those cases.

What Might Not Be Taxable

There's a lot of dispute over what counts as "physical injury" or "physical illness" for the purposes of the IRS. Generally speaking, you have to have something you can point to, like broken bones or bruises. 

It's important to note that the physical illness or injury doesn't have to come first, before the emotional distress, in order to count. If you have a heart attack from stress, and your award relates to both, it's not taxable.

However, there are a lot of areas where the IRS isn't clear about the rules, and there have been cases disputed in court over conditions like PTSD, which is a mental condition that has measurable physical changes.

If you're still negotiating the settlement, you may be able to use your knowledge to negotiate the distribution, since the IRS will often allow the terms of the settlement to dictate how the income is defined on your taxes.

Whether you've already settled a dispute or are about to settle one, speak with your attorney about the tax consequences of the settlement. He or she may recommend a financial adviser. If you haven't yet settled your claim, it's good to know how the taxes will affect your net payment, after taxes. For more information, contact a firm like Gallagher Law Offices PC.