Is My Settlement Taxable?

IRS

One question our Texas injury attorneys hear a lot is:  “Do I have to pay taxes on my personal injury settlement?”

While it’s important to consult with an attorney as soon as possible to discuss all issues in your case, below is an overview of when personal injury awards and settlements can be taxed.

Overview:  Physical Injury Damages Not Taxable; Other Damages Are

Is your lawsuit settlement or jury award subject to income tax?

The answer depends on the type of damage being compensated by the settlement or award.

While exceptions apply, here is an overview:

Is My Lawsuit Award Or Settlement Subject To Federal Income Tax?
Type of Damage Taxable?
Judgment/Settlement "On Account" of Personal Injury or Sickness No
Emotional Distress — Injury Case No
Pain & Suffering — Injury Case No
Mental Anguish — Injury Case No
Loss of Consortium — Injury Case No
Lost Wages — Injury Case No
Workers' Compensation No
Lost Property Value — Injury Case Not Typically
Punitive Damages — All Cases Yes
Interest — All Cases Yes
Judgment/Settlement — Non-Physical Injuries Yes
Mental Anguish — Non-Injury Case Yes
Lost Wages — Non-Injury Case Yes

Physical Injury Damages Are Not Taxable

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Section 104(a)(2) of the Internal Revenue Code (IRC) mandates that compensation paid “on account of” personal injury or sickness is generally not taxable.  This means the federal government does not tax portions of settlements and awards that emanate from physical injuries.

One important exception is that you do have to pay taxes on compensation received for medical expenses if you have deducted the medical expenses on your taxes.

Further, as is discussed below, settlements in cases that do not involve physical injuries are often taxable, as are portions of personal injury settlements that do not emanate from the physical injuries or sickness.

Emotional Damages Are Not Taxable If Caused By Physical Injury

Compensation for pain and suffering, emotional distress, and mental anguish is not taxable as long as it is tied to a personal injury or physical illness.

So, for example, mental anguish damages caused by a truck accident or offshore injury are typically not taxable unless deducted as a medical expense.

On the other hand, if mental anguish is caused when someone defrauds you in a business transaction – damage which is recoverable in Texas and many other states – the associated mental anguish damages are usually taxable as “Other Income.”

Workers’ Compensation Is Not Taxable

Workers’ compensation benefits paid for physical injury or illness are not taxable.

Lost Wages Are Not Taxable If Caused By Physical Injury

Your lost income in a personal injury case is generally not taxable.

Your lost income in other cases may be taxable.

For example, lost business income is often taxable as self-employment income.  Likewise, in employment actions such as suits for wrongful termination, compensation for lost wages is usually taxable.

Loss of Consortium Is Not Taxable

In some cases, a party is entitled to loss of consortium damages.

What is loss of consortium? Loss of consortium is damage stemming from “the mutual right of the husband and wife to that affection, solace, comfort, companionship, society, assistance, sexual relations, emotional support, love, and felicity necessary to a successful marriage.”

Loss of consortium damages are generally not taxable when they emanate from a physical injury or sickness.

Punitive Damages Are Taxable

Punitive damage awards are taxable as “other income” in all types of cases, including personal injury.

A narrow exception exists in certain wrongful death cases.  In some states, like Alabama, local laws provide that in wrongful death cases, only punitive damages can be recovered. In these states, punitive damage compensation in wrongful death cases is generally not subject to income tax.

Interest Is Taxable

Interest on any judgment or settlement is taxable as “Interest Income.”

Lost Property Value Is Generally Not Taxable

The loss in value of property is not taxable if it is less than the adjusted basis of the property. If it is more, the excess is taxable as a capital gain.

Further, in either scenario the adjusted tax basis of the property will need to be reduced to account for lost value.

Illustration

The United States Supreme Court explained when the government can tax lawsuit judgements and settlements as follows:

“Consideration of a typical recovery in a personal injury case illustrates the usual meaning of ‘on account of personal injuries.’

Assume that a taxpayer is in an automobile accident, is injured, and as a result of that injury suffers (a) medical expenses, (b) lost wages, and (c) pain, suffering, and emotional distress that cannot be measured with precision. If the taxpayer settles a resulting lawsuit for $30,000 (and if the taxpayer has not previously deducted her medical expenses . . .), the entire $30,000 would be excludable . . . .

The medical expenses for injuries arising out of the accident clearly constitute damages received ‘on account of personal injuries.’  Similarly, the portion of the settlement intended to compensate for pain and suffering constitutes damages ‘on account of personal injury.’  Finally, the recovery for lost wages is also excludable as being ‘on account of personal injuries,’ as long as the lost wages resulted from time in which the taxpayer was out of work as a result of her injuries.

The critical point this hypothetical illustrates is that each element of the settlement is recoverable not simply because the taxpayer received a tort settlement, but rather because each element of the settlement satisfies the requirement . . . that the damages were received ‘on account of personal injuries or sickness.’”

Every case has its nuances.  Your best bet is to ask your accountant or lawyer whether or not a particular settlement is subject to income tax.

But, generally speaking, if your settlement or award is compensation “on account of” personal injury or sickness, no tax is owed.

Our Houston Injury Lawyers Are Here To Help

If you or a loved one has suffered a personal injury, our Houston injury lawyers can help.

We would be privileged to discuss your case, including the tax consequences of any judgment or settlement, during a free and confidential consultation.

The home offices of Morrow & Sheppard are located in Houston, Texas, but we handle serious personal injury and small business disputes all around the country.

Please contact us now to begin the process.


References

Wal Mart Stores, Inc. v. Alexander, 868 S.W.2d 322 (Tex. 1993) (defining loss of consortium).

Lawsuits, Awards, and Settlements Audit Techniques Guide – IRS 2011.

Publication 4345 – IRS Rev. 4-2015.

Commissioner v. Schleier, 515 U.S. 323 (1995).

**This article is NOT legal advice and is for informational purposes only.**