Do I Have to Pay Tax on an Injury Settlement?

Navigating the aftermath of an injury can be overwhelming, not only due to the physical and emotional toll but also because of the financial implications. One pressing question many people ask about their claim is whether they have to pay tax on an injury settlement. The answer to this question largely depends on the nature of the damages awarded. Understanding the distinction between general damages and special damages is crucial in determining your tax obligations.

General Damages: Non-Taxable Awards

General damages, often referred to as compensatory damages, are awarded to compensate for non-monetary aspects of the injury. These include pain and suffering, emotional distress, and loss of enjoyment of life. Essentially, these damages are intended to compensate for the intangible losses that cannot be easily quantified.

Pain and Suffering

Pain and suffering encompass both the physical discomfort and the emotional trauma that result from an injury. This type of damage is subjective and varies greatly from case to case. The goal is to provide financial relief for the physical pain endured and the psychological impact the injury has had on the individual’s life.

Emotional Distress

Emotional distress refers to the mental anguish and psychological impact of the injury. This can include anxiety, depression, insomnia, and other mental health issues stemming from the incident. Like pain and suffering, emotional distress is a personal and subjective experience, and compensating for it is intended to help the injured party cope with the psychological ramifications of their ordeal.

The Internal Revenue Service (IRS) generally does not tax settlements for pain and suffering or emotional distress, provided these are directly linked to a physical injury or sickness. This is because these awards are seen as a means to make the injured party whole again, rather than as income.

Special Damages: Taxable Awards

Special damages, on the other hand, are awarded to compensate for monetary losses that result from an injury. These include lost wages, future lost income, medical expenses, and property damage. Since these damages are intended to replace actual monetary losses, they are considered taxable by the IRS.

Lost Wages and Future Lost Income

Lost wages are the earnings you missed out on because of your injury. This can cover the period from the injury until the settlement. Future lost income compensates for the loss of future earning potential if the injury has long-term or permanent effects on your ability to work. Because these awards are seen as a replacement for what would have been taxable income, they are subject to taxation.

Medical Expenses

While compensation for medical expenses is often included in settlements, the taxability can be complex. If you have already deducted medical expenses related to the injury on your tax return, any settlement you receive to cover those expenses must be included as income. However, if you did not take such a deduction, the compensation for medical expenses is generally not taxable.

Property Damage

Compensation for property damage is intended to cover the repair or replacement of personal property that was damaged as a result of the injury. Like other special damages, these are considered taxable because they are meant to restore monetary losses.

Strategic Settlement Structuring

When settling a case, you may have some control over how the settlement is allocated between general and special damages. This can have significant tax implications, and careful planning can help minimize your tax burden. Negotiating the terms of the settlement with an eye toward tax efficiency is a crucial step. For instance, if you can allocate a larger portion of the settlement to non-taxable general damages, you may end up with more money in your pocket after taxes.

The Trial Risk

Opting for a trial over a settlement can sometimes lead to higher awards, but it comes with its own set of risks. At trial, the allocation of damages between general and special categories is determined by the court, and you may lose the ability to structure the award in a tax-efficient manner. Additionally, legal fees and other costs associated with a trial can impact the overall amount you receive.

In some cases, a higher award at trial can result in a lower net amount after taxes are considered. For example, if a court awards a large sum for lost wages (which is taxable) and a smaller amount for pain and suffering (which is not taxable), the tax burden can significantly reduce the net amount you receive. The decision whether to settle a case or go to trial should be made after consulting with an experienced injury attorney.

Conclusion

Understanding the tax implications of an injury settlement is essential for making informed decisions about how to proceed with your case. While general damages for pain and suffering and emotional distress are typically non-taxable, special damages for lost wages, future income, and property damage are taxable. At Big River Trial Attorneys we’ve helped our clients recover millions of dollars through settlements and trials. By carefully negotiating your settlement and considering the potential tax consequences, we can help you maximize your financial recovery and reduce your tax liability. Call us today if you have questions about how you should proceed with your personal injury claim.