You may have heard that the vast majority of all personal injury cases settle before or during trial. Once you accept the insurance company's (or the defense attorney's) settlement offer and sign a release, the case is resolved.
So, what happens next? In a perfect world, you get your money quickly (minus the attorney's contingency fee), and you get back to living your life. But Uncle Sam may be entitled to a share of your settlement. Let's look at a few income tax issues as they apply to a personal injury settlement.
As a general rule, the proceeds received from most personal injury claims are not taxable under either federal or state law. It does not matter whether you settled the case before or after filing a personal injury lawsuit in court. It doesn't matter if you went to trial and won a verdict. Neither the federal government (the IRS), nor your state, can tax you on the settlement or verdict proceeds in most personal injury claims. Federal tax law, for one, excludes damages received as a result of personal physical injuries or physical sickness from a taxpayer's gross income.
This means typical personal injury damages that are meant to compensate the claimant for things like lost wages, medical bills, emotional distress, pain and suffering, loss of consortium, and attorney fees are not taxable as long as they come from a personal injury or a physical sickness. A physical sickness means a claim for an illness. If, for example, you were negligently exposed to a germ that made you sick, any damages that you recover as a result of that illness would not be taxable.
Even if you suffer a physical injury or physical sickness, you will be taxed on damages relating to a breach of contract if it is the breach of contract that causes your injury, and the breach of contract is the basis of your lawsuit.
Punitive damages are always taxable. If you have a punitive damages claim, your lawyer will always ask the judge or jury to separate its verdict into compensatory damages and punitive damages. That ensures that you can prove to the IRS that part of the verdict was for compensatory damages, which are not taxable. Get details on the different types of damages in a personal injury case.
One other portion of a personal injury verdict that is taxable is interest on the judgment. Most states have court rules that add interest to the verdict for the length of time that the case has been pending. For example, if you filed your suit on January 1, 2019, you would generally receive interest on the verdict starting from January 1, 2019, and running until you receive payment. If you won at trial on January 10, 2020, but the defendant appeals and does not end up paying you until March 31, 2021, you would receive two years and three months of interest on the amount of the unpaid verdict. This interest is taxable.
Remember that the settlement or verdict is non-taxable only as long as it arose from a physical injury. If, for example, you have a claim for emotional distress or employment discrimination, but no actual physical injury, then your settlement or verdict would be taxable unless you can prove even the slightest amount of physical injury.
Sometimes you might have two claims against the defendant, one of which relates to a personal injury and one of which does not. In this case, especially if the personal injury claim is much larger than the non-personal injury claim, you would want to explicitly state in the settlement agreement what amount of the settlement relates to the personal injury claim and what amount of the settlement relates to the non-personal injury claim.
While the IRS can always challenge the non-taxability of a settlement, specifically allocating your settlement like this gives you the best chance of having most of the settlement excluded from taxation.
Get more in-depth information on resolving your personal injury claim.