Do I Owe Taxes On My Personal Injury Settlement?

Tax Liability On Personal Injury Settlements

If you received a settlement on your personal injury case, you may be wondering if you owe income taxes on it to the IRS.  The IRS has rules regarding whether your settlement can be subject to income tax.  While most personal injury settlements (where there is a physical injury) there is no liability to pay income taxes, there are some exceptions to the rule.

Settlements For A Physical Injury Or Sickness

Many CPA’s do not regularly see clients who have suffered a personal injury and are not aware of the exception involving cases where there has been a “physical injury.”  In general, a settlement that includes a portion for lost wages or is undifferentiated does create a tax liability.  However, the IRS has carved out an exception as described in IRS Publication 4345  that where there is a “physical injury,” then an undifferentiated settlement is not subject to taxation (assuming that you have not deducted itemized medical expenses for the injury).

Things get more complicated if you took an itemized deduction for medical expenses for your injury in any tax year, then you must include in your income the amount of the settlement up to the tax benefit received (basically, the IRS takes away your itemized deduction and you re-pay the government the amount that you deducted).  If you took itemized deductions in multiple years, then you must make a pro-rata allocation for each of the tax years in which you took a deduction.  If this applies to you, this work is best left to your CPA.  The takeaway here is that you only owe income tax on a personal injury settlement if you took an itemized deduction for medical expenses as a result of the injury.  If you did not take any deductions, then you don’t owe any taxes.

Settlements For Something Other Than A Personal Injury

If your claim was an economic claim only (no physical injury), then you will have some tax liability for your settlement.  Examples of claims that are economic only would be for:

• Lost wages or lost profits from a business (unrelated to a physical injury)
• Diminished value of property
• Interest on your claim
• Punitive damages

What Happens If You Go To Trial?

The IRS treats a settlement and a trial verdict the same as long as you have suffered a physical injury.  If your case goes to trial an there is a clearly allocated portion of the court award for lost wages, then the IRS considers the time off of work due to a physical injury as related to the physical injury and, therefore, not taxable (see IRS Lawsuits, Awards, and Settlements Audit Techniques Guide 2011).

Again, I cannot stress enough that the trigger is a physical injury.  If there is not a physical injury involved in your case (i.e. mental anguish only), then you will have an income tax liability.  See Commissioner v. Schleier, 515 U.S. 323 (1995); see Murphy v. IRS, 493 F.3d 170 (2007)(D.C. Circuit sustained the district court’s holding that damages awarded in an administrative action against a former employer under whistleblower environmental statutes, for “mental pain and anguish” and “injury to professional reputation,” were outside the Internal Revenue Code’s “personal physical injuries or physical sickness” damages exclusion, even though the taxpayer no doubt had suffered from certain physical manifestations of the emotional distress on which the award was based); Stadnyk v. Commissioner, T.C. Memo. 2008-289; Ballmer v. Commissioner, T.C. Memo. 2007-295, and Hawkins v. Commissioner, T.C. Memo. 2007-286.

Beware Of  Confidentiality Agreements

If you agreed to a confidential settlement, the portion of your settlement that the other party paid for confidentiality itself is taxable.  This is easier if the agreement specifies an amount attributable to confidentiality.  However, most confidentiality clauses included in personal injury settlements do not specify an amount.

In such a situation where the settlement agreement is silent as to what portion of the defendant’s payment is for confidentiality, a tax court can determine what portion was paid to keep the plaintiff’s silence and that portion becomes taxable.  See Amos v. Commissioner, 83 T.C.M. 663 (2003).

Talk To Us About Your Case

If you have questions about whether you owe income taxes as a result of your settlement, give us a call to discuss your case with a Lakeland personal injury lawyer.  We serve clients with personal injury and medical malpractice matters in Polk County including Lakeland, Winter Haven, Bartow, and Haines City, Florida.