When both parties resolve a legal case outside of court, the plaintiff will receive a settlement much sooner than they would if the case had gone to trial. When a final settlement agreement is reached, the plaintiff and the defendant will waive their rights to pursue any further monetary recovery or legal action from each other. Courts encourage settlements because they allow the parties to develop resolutions that are mutually beneficial and lessen courtroom congestion.
Depending on the type of case and type of compensation a plaintiff receives for the injuries they have suffered, a personal injury settlement can either be partially taxable, nontaxable, or fully taxable. A physical sickness or injury determines the taxable status of a personal injury settlement. While several broad guidelines were set by the Internal Revenue Service (IRS), the types of injuries that are taxable have been up for debate.
Nontaxable Settlements
Gross income includes income from any derived source, according to the IRS. This means that any settlement money that was earned is taxable, with the exception of physical or personal injuries.
Physical Illness or Personal Physical Injuries
If the settlement you received for a physical illness or physical injury didn’t include an itemized deduction for injury or illness-related medical expenses, the entire amount is nontaxable. These proceeds should not be included as part of your overall income.
Any portion of your settlement used for physical sickness or injury should be included as income intended for medical expenses that were deducted in past years if they provided you with a tax benefit. The proceeds used for medical expenses must be allocated on a pro-rata basis for each year you paid them if part of your proceeds were used to cover medical costs over multiple years.
Mental Anguish/Emotional Stress
Any proceeds you receive for mental anguish or emotional stress stemming from a physical sickness or personal injury are treated exactly like the proceeds you would receive for a physical sickness or personal injury.
If these proceeds didn’t originate from a physical sickness or personal injury, they must be included as part of your income. This amount will be reduced if medical expenses for anguish and distress that were deducted previously didn’t provide you with a tax benefit or amounts paid for medical expenses related to mental anguish or emotional distress were not deducted previously.
Taxable Settlements
Lost Profits or Wages
If you were in an employment-related lawsuit, for instance, and you received a settlement for a workplace-related injury or unlawful discrimination, any portion of the proceeds used to cover lost wages, including front pay, back pay, or severance pay, is taxable. The settlement is also subject to Medicare and social security tax rates and the social security wage base in effect.
Punitive Damages
An injured plaintiff can be awarded money that punishes the wrongdoer, which goes beyond the ordinary compensation they would receive for an injury. The legal term for this is known as punitive damages, which are usually taxable. Regardless of whether the individual is physically sick or physical injuries, punitive damages are subject to limited exceptions. (Learn more about damages here).
More Important Tax Information
Other things you need to take into consideration when filing taxes after receiving a settlement include:
- Lost Property Value: If you receive a settlement for lost property values less than your property’s adjusted basis, they do not need to be reported on your tax return because they are not taxable. Your property’s basis must be reduced by the settlement amount to avoid paying taxes on it. If the settlement is more than your property’s adjusted basis, the excess amount is considered income and must be reported.
- Interest: Any interest that is part of your settlement amount is considered taxable and must be reported on Form 1040 under line 2b.
- Health Insurance Marketplace: If you, your spouse, or a dependent enrolled in health coverage on the Health Insurance Marketplace website and the insurance company has already received advance payments of the premium tax credit, you must inform the Marketplace of a change in circumstances if you received a taxable settlement that increased your overall income for the year. This will allow the Marketplace to adjust your advance credit payment amount, so you won’t have an increase in your overall tax liability and large discrepancies between the premium tax credit you are allowed and your advance credit payments.
How to Ensure That Most of Your Settlement Will Be Nontaxable
You may have two lawsuits against a defendant – one for a personal injury and another for a non-personal injury. You will want to specifically state in your settlement agreement the portion of the settlement related to your personal injury claim and the portion of the settlement that relates to your non-personal injury claim, especially if the amount for the personal injury claim is significantly larger.
A settlement’s non-taxability can be challenged, but you will have a better chance of avoiding taxation on most of your settlement amount if your settlement is allocated.
Before You Settle, Get Advice From a Personal Injury Attorney
While there are exceptions to most legal and tax-related rules, it’s recommended that you contact a personal injury attorney before accepting a personal injury settlement. The attorney can give you a complete analysis of some tax consequences related to specific personal injury settlements and negotiate more favorable terms.
For financial assistance during your lawsuit or after a settlement agreement has been determined, contact The Legal Funding Group.
