True or False? Verdicts or settlements received due to personal injuries are tax free.
Answer: It Depends.
A lot of people are under the misperception that if they receive monies in a personal injury settlement or verdict, that they do not have to pay tax on those monies. This is not necessarily correct.
While this is an overview of the taxability of personal injury recoveries, it is imperative that you consult with your accountant to make sure that you are and have properly reported any and all necessary personal injury recoveries.
The question then becomes: What and when do I have to include the proceeds of a personal injury recovery in my income?
According to the Internal Revenue Service Pub. 4345 (Rev. 4-2015), “[a] settlement payment may consist of multiple elements that have been allocated by the parties. For example, an agreement may include allocations to back pay, emotional distress, and attorneys’ fees. Generally, the IRS will not disturb an allocation if it is consistent with the substance of the settled claims.” (Emphasis added)
The IRS breaks up damage recoveries into several categories:
1. Personal physical injuries or physical sickness.
Rule: “If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable and does not have to be included in your income.” Id. (Emphasis added).
However, “you must include in income that portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit. In addition, if part of the proceeds is for medical expenses you paid in more than one year, you must allocate on a pro rata basis the part of the proceeds for medical expenses to each of the years you paid medical expenses.” Id. For more information, see IRS Publication 525.
2. Emotional distress or mental anguish.
Rule: “The proceeds you receive for emotional distress or mental anguish originating from a personal physical injury or physical sickness are treated the same as proceeds received for personal physical injuries of physical sickness.” Id.(Emphasis added).
However, “if the proceeds you receive for emotional distress or mental anguish do not originate from a personal physical injury or physical sickness, you must include them in your income.” Id. (Emphasis added). But, the “amount you must include is reduced by: (1) amounts paid for medical expenses attributable to emotional distress or mental anguish no previously deducted and (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.” YOU MUST ATTACH TO YOUR RETURN A STATEMENT SHOWING THE ENTIRE SETTLEMENT AMOUNT LESS RELATED MEDICAL COSTS NOT PREVIOUSLY DEDUCTED AND MEDICAL COSTS PREVIOUSLY DEDUCTED FOR WHICH THERE WAS NO TAX BENEFIT. Id. (Emphasis added).
3. Lost wages or lost profits.
Rule: “if you receive a settlement in an employment-related lawsuit” (e.g., unlawful discrimination, involuntary termination) and you receive: front pay, severance pay, or back pay – those amounts are taxable wages and subject to social security wage base and social security and Medicare tax rates in effect in the year paid. Further, those proceeds are also subject to employment tax withholding by the payor and should be reported. Id.
But what if I’m self-employed?
“If you receive a settlement for lost profits from your trade or business, the portion of the proceeds attributable to the carrying on of your trade or business is net earnings subject to self-employment tax. These proceeds are taxable and should be…” reported. Id. For more information, see Publication 334.
4. Loss-in-value of property.
Rule: “Property settlements for loss in value of property that are less than the adjusted basis of your property are not taxable and generally do not need to be reported on your tax return. However, you must reduce your basis in the property by the amount of the settlement.” Id.
Also, “if the property settlement exceeds your adjusted basis in the property, the excess is income.” Id.
5. Interest and Punitive Damages.
Rule: “Interest on any settlement is generally taxable as ‘Interest Income’ and should be reported.” Id.
Rule: “Punitive damages are taxable and should be reported as ‘Other Income’….” Id.
The final and sixth category of critical importance is Confidentiality and when a portion of a recovery in a Confidential Settlement Agreement may be considered taxable income.
Rule: If you have signed a confidential settlement agreement and have not allocated a portion of the recovery for the payment of the confidentiality provision, the IRS may review the confidential settlement agreement and determine on its own what the value of the confidentiality provision is worth. Accordingly, that portion of the recovery may be subject to taxable consequences and the remaining portion of the recovery is subject to 1-5 above. See Amos v. Commissioner of Internal Revenue, 2003 WL 22839795 (U.S. Tax Ct., 2003) (holding “if a settlement agreement lacks express language stating what the amount paid pursuant to that agreement was to settle, the intent of the of the payor is critical to that determination.”).
If you have been injured, call us today at 561-533-6700 for a risk-free no-cost consultation.