One of the most important issues for our clients to address after a large personal injury settlement is whether or not they owe income taxes on the money collected. While a quick Google search of “Do I have to pay taxes on my personal injury settlement?” generally comes up with a simple, “No,” the real answer is “Maybe.” Like most legal questions, it is the specific facts of your situation that will ultimately determine the answer.
It is important to understand that a lump sum check may actually represent different types of payments. Some examples are:
- Medical expenses being reimbursed
- Future medical costs that are expected to be paid
- Attorneys Fees
- Court costs/litigation costs
- Pain and Suffering (physical)
- Emotional Distress/Mental Anguish (mental)
- Payment for time lost at work
- Punitive damages (designed simply to punish the wrongdoer and prevent future incidents)
Generally, the IRS will not disturb an allocation if it is consistent with the substance of the settled claims. IRS Publication 4345.
Personal Physical Injuries or Physical Sickness
The full amount of a settlement for personal physical injuries or physical sickness is non-taxable at the state and federal level, if you did not take an itemized deduction for medical expenses related to the injury or sickness in prior years.
However, if you receive a settlement for personal physical injuries or physical sickness, you must include in your income that portion of the settlement that is for medical expenses that you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit. If you paid in more than one year, you must allocate that income on a pro rata basis. See “Recoveries” in Publication 525 for details on how to calculate the amount to report.
The tax benefit amount should be reported as “Other Income” on line 21 of Form 1040.
Emotional Distress or Mental Anguish
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 or physical sickness above.
However, money paid for emotional distress or mental anguish that is not based on a personal physical injury or physical sickness must be included in your income.
The amount you must include is reduced by: (1) amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted and (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.
The net taxable amount should be reported as “Other Income” on line 21 of Form 1040.
Lost Wages or Lost Profits
If you receive an allocation for lost wages, the portion of the proceeds that is for lost wages is taxable wages and subject to the social security wage base and social security and Medicare tax rates in effect in the year paid.
These proceeds are subject to employment tax withholding by the payor and should be reported by you as ‘Wages, salaries, tips, etc.” on line 7 of Form 1040.
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 included in your “Business income” reported on line 12 of Form 1040. These proceeds are also included on line 2 of Schedule SE (Form 1040) when figuring self-employment tax.
Loss-In-Value of Property
Property settlements for loss in value of property (land, house, automobile, etc.) 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.
If the property settlement exceeds your adjusted basis in the property, the excess is income. For more information, see the Instructions for Schedule D, (Form 1040) Capital Gains and Losses and the Instructions for Form 4797, Sales of Business Property.
Interest on any settlement is generally taxable as “Interest Income” and should be reported on line 8a of Form 1040.
Punitive damages are taxable.
They should be reported as “Other Income” on line 21 of Form 1040, even if the punitive damages were received in a settlement for personal physical injuries or physical sickness.
Estimated Tax Payments
Some settlement recipients may need to make estimated tax payments if they expect their tax to be $1,000 or more after subtracting credits & withholding.
Information on estimated taxes can be found in IRS Publication 505, Tax Withholding and Estimated Tax, and in Form 1040-ES, Estimated Tax for Individuals.
Important Note: This post should not be treated as tax or legal advice. While we have made every effort to be up to date at the time this post was written, tax law is notorious for changing swiftly and failure to follow current tax law can get you into trouble quickly, as the IRS does not care what you understood from a blog entry. Any questions particular to your situation should be addressed with a Certified Public Accountant.