A question most commonly asked by personal injury victims is whether they must pay income tax on personal injury settlements. And well, this is a question valid considering that the Internal Revenue Service (IRS) collects taxes on almost everything.
So, do you pay taxes on personal injury settlement? Some good news for you! Your chances of parting with cash in the form of tax from your personal injury settlement are very low. Generally, proceeds from personal injury claims are not taxable.
But there are circumstances where you may be required to pay tax on your personal injury settlement. It all depends on the type of damages awarded for your case.
Wish to know whether your personal injury settlement is subject to tax? Then this article is for you!
Do You Pay Taxes on Personal Injury Settlements?
Every income earner knows how notorious the IRS is at taxing sources of income. Whether you won from gambling or robbed a bank, the IRS will expect you to include it all in your tax return!
But what about personal injury settlement? Do you have to pay federal taxes on personal injury settlements?
No, you don’t. IRS regulations prevent the federal government from imposing a tax on personal injury settlements.
But here’s the catch: There are exceptions for tax exceptions for personal injury settlements.
Tax inclusion or exemption on your personal injury settlement will thus depend on the type of damages awarded for your case.
Physical Injuries and Sickness
The American tax laws exempt tax for damages incurred from personal physical injuries or sickness. Your settlement remains untaxable as long as you didn’t take an itemized tax deduction for medical costs associated with that injury or illness thereof.
But you may be required to pay taxes if:
- You subtracted medical costs from the tax benefits of the formative years via Form 1040.
- You took a tax deduction for a year or more. You’ll need to pay taxes for it from your compensation on a pro-rata
- Part of your settlements is for medical costs that you covered using your taxable income, and you should include it in your taxable income
Pain and Suffering
Sometimes you experience emotional distress due to a personal injury. Usually, you will receive compensation for pain and suffering when this happens. The compensation amount is taxable.
Pain and suffering damages are not treated as compensation for injuries or sickness.
Notably, section 104(a)(2) of the constitution does not consider mental anguish an injury or illness. Your settlement is taxable if your pain and suffering are not directly associated with the personal injury.
One of the ways through which individuals receive compensation in a personal injury lawsuit is punitive damages.
Punitive damages don’t count as a form of the settlement agreement because it applies when the defendant refuses to pay for damages. Instead, the jury imposes punitive damages on the defendant to punish them for their bad conduct.
This form of compensation is taxable because it is a monetary reward to you as a plaintiff, even though its primary purpose was to punish the defendant.
Any money you receive as compensation for damages to your property, say car or home, is not taxable.
This is because whatever you’re getting is not a handout. You’re only getting cash back for an item you owned before but lost to a personal injury anyway. That means this cannot count as income on your side.
What Are the Tax Laws About Work Settlements for Personal Injury?
There are no taxes on work settlements for personal injury. Generally, employee settlements are exempt from tax under the Workers’ Compensation Act.
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According to the IRS, any amounts you receive as workers’ compensation for an occupational injury or sickness are wholly tax-exempt. But this tax exemption only applies if the settlement is paid under a workers’ compensation act or a statute that takes the form of a worker’s compensation act.
Put another way, compensation awarded due to work-related injury is exempt from tax. You will not be required to pay any taxes on them.
Even the settlement payout that the next of kin receives after a fatal incident to a worker is considered tax-free.
Exception to the Workers’ Compensation Tax Rule
An injured worker might be receiving supplemental security income on top of their workers’ compensation. In such a case, the supplemental income is subject to taxation.
Typically, part of your workers’ compensation benefits is taxed if you receive Social Security Disability Insurance (SSID) or supplemental Social Security Income (SSI).
So, payments from social security may be reduced, and a tax imposed on the resulting difference from workers’ compensation.
How and When Workers’ Compensation is Taxable
When it comes to settlement for injuries to workers, the most basic question is: did the injury occur at the place of work?
Workers’ compensation settlements are not considered taxable income at state or federal levels.
As earlier mentioned, an exception applies if you’re also collecting disability benefits through the SSDI and SSI.
Such eventualities rarely happen, though. And when it does, the Social Security Administration (SSA) reduces your SSDI and SSI to limit your total workers’ compensation to a specific threshold. This reduction is referred to as workers’ compensation offset.
SSA reduces the amount from your disability settlement to the same amount you pay in taxable workers’ compensation.
For example, if social security awards you a workers’ compensation offset of $200, this $200 is taxable.
How Does the IRS Collect Settlement Taxes?
Like any other income, you report your personal injury settlement amount to the IRS when filing tax returns for the preceding year. It’s advisable to consult with a tax lawyer before filing returns on personal injury settlements.
Whether you consult or not, the general rule is that you:
- Mustn’t report compensatory awards for physical injury or sickness as income
- Should report punitive damages or other taxable awards as income on the tax report
- Should report lost wages obtained during a settlement
Attorney fees are counted as part of the reward in these taxable cases. The IRS might tax you from the total settlement amount even if part of it was used to pay the attorney.
Luckily, you can use the help of an experienced personal injury attorney to structure a settlement to reduce the tax liability burden to the IRS.
So, are personal injury settlements taxable? The answer is no. Personal injury settlements are among the few cases that are exempt from tax.
But it all boils down to the type of settlement you are receiving. You will pay tax for punitive damages but not for worker compensation.
The whole tax issue can be pretty confusing. You could use the help of an experienced attorney to address concerns about taxes associated with your injury settlement.
Legal Giant has the best attorneys who will help at every stage of your case. Call Us for a consultation today.