Personal injury settlements or verdicts give accident victims the compensation they need to be “made whole.” Damages awards and settlements are intended to return the accident victim to the condition he or she was in before the accident occurred. If accident victims had to pay income tax on the money they receive to reimburse them for expenses or to compensate them for pain, that purpose would be undermined — they would be made less than whole.
Fortunately, a personal injury settlement is usually tax free. Unfortunately, the rule isn’t always that simple. As a general principle, compensation for physical injuries or wrongful death caused by another person’s negligence is not taxed. The rule is different, however, when the compensation involves personal injuries other than physical injuries or when punitive damages are awarded.
To explain the rule, we’ll examine the different kinds of compensation that are usually awarded in a personal injury case.
Jury awards and settlements include out-of-pocket expenses that the injury victim paid for medical treatment as a result of the injury, as well as future medical expenses the injury victim is likely to incur. Compensation is also paid to cover any obligation the accident victim has to reimburse health insurance companies that pay medical expenses on the victim’s behalf. That obligation, known as “subrogation,” varies from case to case.
Reimbursement for medical expenses is not taxed, provided that the medical expenses are related to a physical injury. Even if the medical expenses relate to the treatment of emotional distress, they will not be taxed, as long as the emotional distress resulted from a physical injury. When reimbursement is for treatment of emotional distress that was not caused by a physical injury, it is best to consult a tax advisor to decide whether the reimbursement is taxable.
On occasion, an accident victim might recover more in medical expenses than the victim actually paid out of the victim’s own pocket. Among other reasons, that can happen as the result of negotiations with the insurance company that holds a subrogation claim. Although the injury victim might be seen as making a “profit” when that happens, the receipt of medical expenses for a physical injury is not subject to taxation.
Payment of future medical expenses are not taxed, even if they are not incurred, as long as they are awarded in a claim that arose from a physical injury. Compensation for future medical expenses involves an estimate of the medical costs the accident victim will likely incur in the future. For example, if the victim recovers $10,000 for future surgery and it turns out that the victim will not need the surgery, the $10,000 is not taxed, even if it might be a windfall for the accident victim. The fact that the compensation is related to a physical injury makes it nontaxable.
The umbrella term “pain and suffering” covers a number of related concepts, including compensation for physical pain, emotional suffering, mental anguish, humiliation, and inconvenience that results from a personal injury. No compensation can make pain go away, but an award of damages helps to make an accident victim whole by providing funds that help the victim compensate for pain and suffering.
For example, a person who has been forced to endure substantial pain after an accident may be awarded damages that will help the victim offset the pain with future pleasure. The victim may decide to take a vacation or to pursue an expensive hobby that will take the victim’s mind off the suffering that the victim experienced.
How a victim chooses to spend the compensation received for pain and suffering is up to the victim. Whatever choice the victim makes, the compensation is not subject to taxation, provided the pain and suffering was caused by a physical injury.
Under limited circumstances, personal injury compensation is available for emotional distress in the absence of a physical injury. In those cases, the compensation is usually taxable. In most personal injury cases, however, emotional distress is caused by a physical injury and is therefore nontaxable.
When an accident causes a victim to miss work, the victim is entitled to recover lost income as part of a settlement or verdict. Congress has the authority to tax awards of damages that replace gross income. However, Congress has generally chosen not to do so. Since the federal income tax code was first enacted in 1918, Congress has exempted damages received from personal injuries, including settlements or verdicts in negligence lawsuits and wrongful death actions. Congress has made the same choice with regard to compensation for a loss of future earning capacity.
The exemption of awards for lost income from taxation is usually regarded as having a humanitarian purpose. Unfortunately, in 1996 Congress decided to limit its humanitarian inclinations. The law was amended that year to exclude compensation for lost income that does not relate to physical injuries. Most personal injury cases involve physical injuries, however, so most claims for lost income are not taxed.
While Congress has chosen not to tax compensation for physical injuries, it does allow taxation of compensation for injuries that do not involve physical harm.For example, compensation for employment discrimination, defamation, invasion of privacy, false imprisonment, emotional distress that is not caused by a physical injury, and other kinds of wrongs that do not involve physical harm are generally taxable.
In addition, Congress has chosen to make punitive damages taxable, even in cases that involve physical injuries. Juries award punitive damages to punish a party that behaved maliciously or in reckless disregard of the victim’s rights. For example, a car accident victim who was injured by a drunk driver may be able to recover punitive damages. If that happens, however, the punitive damages award will be taxable.
Sometimes, whether compensation is taxable will depend on how a settlement is worded. Having a personal injury lawyer who understands the tax implications of personal injury settlements can make a difference in whether the victim pays taxes on a settlement.