It’s a common fear among those seeking compensation for car accident injuries: Their attorney negotiates a settlement that fairly compensates them, only to have the Internal Revenue Service take a large portion of the funds for taxes.
While it’s easy to see this concern, the IRS generally does not tax proceeds received from personal injury settlements or lawsuits, with some exceptions.
Here is a look at the issue of taxes and settlements.
What the IRS Has to Say
You must report nearly all income to the Internal Revenue Service (IRS) , including wages and other types of compensation derived from work, the gross income of a business that the taxpayer owns, rents, interest, royalties, pensions, and more. The taxpayer’s total income for the year is known as their gross income.
From this total, taxpayers can make certain adjustments, such as payments to a retirement account and a standardized or itemized deduction for allowable expenses. The IRS considers the total after these adjustments the taxpayer’s adjusted gross income or taxable income.
However, as the IRS notes in its Publication 4345, it doesn’t consider the compensation received for personal injuries or physical illness through a settlement or a lawsuit income and, therefore, does not tax it. This rule applies whether you receive the compensation through a negotiated settlement or a court verdict. The IRS asks taxpayers receiving compensation for damages incurred in an accident that resulted in bodily injury not to report it on their tax returns.
What About Settlements That Include Income Loss?
Certain lawsuits, such as lawsuits involving discrimination in the workplace, can involve compensation for back pay, front pay, and severance. The IRS may tax compensation for this income, as it would the income itself—if the injured person was healthy enough to work those lost hours.
In these claims, the IRS would consider the award taxable and subject it to the Social Security wage base and Social Security and Medicare tax rates for the tax year of the award. In other civil claims besides personal injury claims, the taxpayer must report wage loss compensation received on line 1a of Form 1040.
As explained in Publication 4345, wage loss compensation is often included in personal injury settlements or awards. Generally, the IRS will not tax it.
What From Personal Injury Settlement Proceeds Can the IRS Tax?
Personal injury settlements often contain allocations for several different injuries suffered by the claimant, including wage loss, medical expenses, emotional distress, and attorney’s fees. The IRS states that it generally will not disturb these allocations, provided they are consistent with the substance of the claim. However, certain types of compensation can still be subject to tax.
Punitive damages—also known as exemplary damages—involve compensation awarded to a claimant in addition to the compensatory damages for the expenses and impacts of the physical harm and property damage they incurred in the accident. This compensation is rare. The court awards punitive damages as a financial punishment for a defendant who intentionally causes harm to another.
Because punitive damages are not awarded as compensation for the injury or illness but rather as a consequence, the amount received for punitive damages is considered income and is subject to tax. The punitive damages received for the claim are reported as “Other Income” on line 8z of Form 1040, Schedule
The only time punitive damages are generally considered not to be income and not taxable is when they pertain to an award made for a wrongful death lawsuit in certain states where only punitive damages are available for that type of claim. Wrongful death claims involve compensation paid to the family member of an individual killed in a car accident or other type of accident resulting from someone else’s negligence.
Federal tax law permits taxpayers to claim certain types of expenses as itemized deductions to reduce their taxable income and, as a result, reduce the amount of tax they owe. One of the types of itemized deductions that taxpayers can take is payments they made for medical expenses incurred by themselves, their spouse, or their dependents during the tax year.
The medical expenses you can deduct include:
- Payments of fees to health care providers such as doctors, dentists, surgeons, chiropractors, psychiatrists, and psychologists.
- Payments for inpatient hospital care or residential long-term nursing care.
- Payments for false teeth, reading or prescription glasses, contact lenses, hearing aids, wheelchairs or crutches, or a guide dog to assist a taxpayer, their spouse, or dependent with physical disabilities.
- Payments for transportation to a medical facility to receive care.
- Payments for insurance premiums for a policy that covers your medical care.
Settling a personal injury claim can be time-consuming, sometimes lasting through multiple tax years. You are permitted to claim the expenses you incurred as a result of medical treatments you paid on your own through a health insurance policy exceeding 7.5 percent of your adjusted gross income for the year.
However, if you receive a settlement on your personal injury claim in a subsequent tax year that includes compensation for medical expenses, you must report the amount of the itemized deduction you took for those expenses as income.
What About Emotional Distress?
The compensation you receive for emotional distress accompanying a physical injury sustained in a car accident is part of the greater compensatory award. It is not generally considered income or subject to tax. However, if you seek compensation for harm that does not involve physical injury, such as an employment or breach of contract claim, and it doesn’t involve medical treatments for physical manifestations of that emotional distress, you may have to pay tax on your emotional distress damages.
If the Accident Only Involved Property Damage, Will You Owe Taxes?
According to the National Highway Traffic Safety Administration, accidents featuring only property damage, without bodily injury, are the most common type of car accident reported, to the tune of around 4 million of this type of accident a year. Taxes are generally not owed on settlements received for the reimbursement paid to you by an at-fault party’s insurer for damages to your car.
Can the IRS Take Your Personal Injury Award if You Owe Back Taxes?
In some cases, yes. If you owe back taxes and a tax lien is in place, the IRS can lay claim to a portion of your settlement award to satisfy the lien. This scenario generally occurs when you deposit the proceeds of your award into your personal bank account. As the IRS explains, a federal tax lien is the government’s legal claim against your property if you fail to pay your tax debt.
What You Do With the Money After You Receive It Can Also Result in Taxes
While the compensatory award you receive for the expenses and impacts incurred in a car accident is generally not taxable, you can still incur tax, depending on what you do with the money. For example, if you decide to take the proceeds from your settlement and invest the money in the stock market and make money off that investment, the IRS will tax the money you make.
Can You Deduct the Cost of Your Attorney’s Fees?
In many types of civil claims, the claimant can reduce their overall tax burden by deducting certain expenses related to their claim. For example, in personal injury claims, the claimant is permitted to deduct the expenses they paid for their medical treatment. This allowance understands that if you receive a settlement, it includes payment of those expenses. You must report the deduction amount taken as income and the IRS may tax it.
Likewise, in civil claims that do not involve personal injury, the claimant is permitted to deduct the expenses they pay to their attorney during one tax year, with the understanding that the deduction will be subject to tax in a subsequent year’s filing when compensation is received that covers attorney’s fees.
However, in personal injury claims, the fee attorneys charge their client is contingent on a successful outcome. That fee is due when compensation for the claim is received rather than during the process. This billing method involves a legal agreement entered into by the attorney and the claimant when they begin working together on the claim. The agreement outlines the type of services that your attorney will provide for you and sets a percentage of any proceeds received on the claim as payment.
Attorneys calculate fees into the value of the claim, which you don’t report as income, except for any compensation received for punitive damages. Because of this, taking itemized deductions for the amount you pay for your personal injury lawyer is not appropriate.
Seek Help if You Don’t Know How to Treat Your Settlement When Filing Taxes
An attorney can answer basic legal questions about your compensation and taxes. However, if you have specific concerns about the potential impact of itemized deductions for medical treatments you received throughout the year or any other issues related to your claim that could impact the amount of taxes you owe, a licensed or certified tax or financial professional is likely your best source of information.
Some of the guidance that your attorney can give you to help you in consultations with your financial advisor include information about the potential settlement range for your claim, the likelihood that your claim will go to trial, the damages you are entitled to receive, and the most effective method of obtaining compensation for your claim.
Your attorney can also provide information on the statute of limitations for filing your claim, which can have a tremendous impact on the compensation you receive. The statute of limitations is the deadline for filing a personal injury lawsuit in court.
If you allow this deadline to pass without filing a legal claim, you not only stand to lose the right to use the court process when seeking compensation for the financial and emotional costs of your injury but also generally lose the right to settle the claim as well. The statute of limitations varies, depending on the state where the claim is filed.
The insurance provider who issues payment on the claim should provide a 1099-Miscellaneous form to help you determine whether any of your settlement needs to be reported to the IRS.
Contact the Dolman Law Group Today
When drivers are injured in an accident but don't know where or how to begin the process for compensation, we are here to assist you. Please get in touch with us as soon as possible. Do not hesitate to reach out and schedule a free consultation today with the Dolman Law Group.