The Taxability of Personal Injury Settlements
By Sean Lally, Staff Writer
Whether it’s due to a change in tax law or unforeseen circumstances, tax season can be an utterly confusing time of year. For instance, you may have been the unfortunate victim in a personal injury case that ended in a settlement of medium to high value. With no experience in this area, you may be wondering: are personal injury settlements taxed?
To begin with, in most cases, medical bills and non-economic (or pain and suffering) damages are not categorized as income. Thus, settlement payments associated with these damages are not taxable. However, if part of the medical expenses covered by the settlement were deducted in years prior and resulted in a tax benefit, then that portion of the settlement should be reported with income when you file your taxes.
Notes on Non-Economic Damages
The same basic principal applies to pain and suffering damages, which include emotional turmoil, anguish and other intangible effects of the injury. Additionally, the distress must be directly linked to a personal physical injury or a physical sickness; otherwise, that portion of the settlement should be included in reported income. There are two ways in which that sum may be reduced:
- Any money spent on medical bills directly related to the emotional stress in question can reduce the taxable amount
- And previous deductions related to emotional distress that did not result in a tax benefit may also go toward a reduction
Wages and Profits
Any lost wages or profits that are covered in the settlement should be reported as income. The idea is that, had you been paid this money originally, it would have been taxed as income. Thus, it should be taxed now since it is, in fact, compensation for that income. Lost wages should be reported as ‘Wages, salaries, tips, etc.” on line 7 of Form 1040 and lost business profits should be reported as “Business income” on line 12 of Form 1040.
Additionally, punitive damages – or damages awarded when the defendant conduct has been found to be particularly egregious – are also taxable. These should be reported as “Other Income” on line 21 of Form 1040.
Beware of the Confidentiality Clause
Sometimes corporate defendants may want to include a confidentiality clause in the settlement, a move that appears harmless on the surface. In actuality, it could cost you a great deal of money. In the eyes of the IRS, such a clause is taxable because it involves a contractual exchange of money in exchange for silence. It is assumed that an exchange takes place because, according to contract law, a binding agreement includes two things: mutuality and consideration. Mutuality, in this case, is covered by the contractual exchange mentioned above and the consideration is the compensation given in exchange for said silence.
It is very important to include the consideration in your deliberations leading up to the settlement. If no amount is given, the IRS has the right to name a “just and fair” amount.
The Importance of Clarity
A good personal injury lawyer will include the exigencies of taxation in his or her negotiations, clarifying along the way the exact terms of the agreement. As suggested above, confidentiality agreements should be avoided when possible. If it can’t be avoided, the lawyer should be very clear about the amount of consideration being proposed in exchange for silence.
In the most complicated cases, it might be advisable to hire a certified public accountant to help sort through all the intricacies of settlement-related taxes.