Paying Taxes on Your Personal Injury Settlement: Essential Information for Clients

The Basics of Personal Injury Settlements

A personal injury settlement is a compromise between parties that results in an agreement that one party will pay the other a sum of money to resolve their claim rather than continue a legal battle that could end with either party or both parties losing. These agreements can be reached at any point during the process and can be verbally agreed upon or put in writing. There is a special class of settlement that applies to minors, but otherwise rules around these settlements can vary from state to state. However, once the agreement is reached it is almost never for a one time payment. Generally, there are multiple types of damages agreed upon that will be paid as part of the settlement. This means that in addition to the sum agreed upon, the parties will also reach an agreement about what is included in it.
Medical bills are one of the most common forms of damages included in a settlement , as the payment will be used to cover this category. This payment may not even go directly to the individual but instead to the hospital or provider. Some personal injury settlements will even include the specific use of the payment towards bills if there are multiple parties involved. That said, the person receiving the settlement almost always has the right to choose the provider if they have not already been assigned. Along with this the injured party may receive compensation for pain and suffering. This payment involves more than the physical injuries and instead is meant to compensate the individual for the emotional consequences of whatever injury has occurred and the effects on their life.
Lost wages may also be included as part of a settlement. Although in some cases insurance companies will pay lost wages directly to the medical provider or other creditors, in others they will pay the injured party. These payments will be determined by the severity of the injury and the extent to which it was limiting.

IRS Directives Regarding Taxation

The Internal Revenue Service (IRS) does not assess taxes on all awards received as the result of a personal injury settlement. However, the IRS does tax money awarded for punitive damages, which are payments given to a victim based on malicious intent or deliberate disregard of safety by a defendant. They also generally assess taxes on portions of settlements meant to cover lost wages or income that the plaintiff would have earned if they had not sustained an injury. Structuring settlements as equal periodic payments over time will defer tax payments until the money is disbursed, seeing as the IRS currently has a low rate of interest. The IRS is not concerned with the reason for the award, but rather sees it simply as a personal investment that should not be taxed until the investment is disbursed in full. Recently, a settlement structured as part lump sum and part annuity was taxed on the lump sum portion; courts have further held that annuity payments later distributed to spouses or heirs are also not taxed. Thus, the IRS does not see structured settlements as a way to avoid taxes.

Taxable and Non-Taxable Elements

Settlements and verdicts for personal injury claims typically consist of both taxable and non-taxable settlement components. The following is a general summary; nonetheless we encourage individuals to review this with their own tax advisor.
Any damages award received wholly on account of physical injury or physical sickness is not included in an individual’s gross income and therefore not taxable. A physical injury is a physical or mental condition resulting only from a traumatic event or an ongoing phenomenon of bodily malfunction. If a settlement includes taxable and nontaxable damage components, the taxpayer can allocate the award among the categories and receive favorable tax treatment of the nontaxable amount.
Interest on a damages award is separately taxable as interest income. An award for punitive damages is separately taxable. Punitive damages are amounts added to a damages award, above that required to compensate for the injuries, if the defendant’s conduct rises to the level of extreme outrage or gross negligence. These are also taxable as income.
For example, if a settlement included physical injury damages, as well as punitive and interest components, the plaintiff would have the tax benefit of allocating the interest and punitive damages to the taxable portion of the settlement. For example, if $5,000 of interest and $5,000 of punitive damages were paid in conjunction with $40,000 of physical injury damages, the entire $10,000 could be allocated to the $10,000 of taxable damages and be excluded from tax on the $40,000 of physical injury damages.

How to Reduce Settlement Taxes

Of course, there are some overall tax minimization strategies that you can use to reduce your tax liability on a personal injury settlement. The most important thing is that you structure the settlement. A structured settlement is essentially a settlement that pays you out over time instead of all at once . If you receive a present value answer, you have the option to take a lump sum payment or to structure a settlement over a period of time. The payments are generally tax free for federal income tax purposes. Another way to minimize your tax exposure is to speak with a CPA or tax attorney. He or she can advise you as to the best legal ways to minimize your tax liability.

State Approaches to Taxation

The taxation of personal injury settlements can vary depending on the state in which the settlement is received. It is important to be aware of the differing state tax laws and considerations that may apply to your settlement. For example, while some states follow federal law in exempting compensatory personal injury damages from taxation, others do not.
Georgia law follows the federal government but has a specific exception for punitive damages, which are taxable in Georgia. Illinois law requires tax be paid on the full amount of a settlement unless the settlement is labeled "compensatory." In Illinois, any punitive damages are not only taxed but taxed at a rate that approximates the lowest corporate tax rate.
Washington state brings a different consideration to the settlement equation. Washington state, one of the few states that does not impose an income tax, does not have a tax on compensatory damages for personal injury claims. Washington does, however, require taxes on punitive damages which it classifies as unintentional profits from the use of an asset or privilege and taxes at the higher business and occupation tax rate. A word of caution: If you live in a state that does not impose state income tax, you still may be on the hook for federal taxes even if your settlement is characterized as compensatory and does not have the punitive damages component.

Consulting an Accountant

The best way to be sure that you comply with all the rules and meet your obligations is to consult with a tax professional. A lawyer cannot give you advice about taxation at the detailed level. So if you are from Chicago the best bet is a tax attorney from one of the top firms in the State of Illinois like Winston & Strawn or Mayer Brown , both of Chicago.
Often times a tax professional will have a relationship with a lawyer where they work together as a team on a case as often tax consequences interplay with personal injury settlements. Your case is unlike the majority of litigation and lawyers who don’t do this work all the time may not realize there are tax issues at all.