Taxable or Not Taxable. That is the Question

A question often asked by those who have received settlements in personal injury lawsuits is whether they must include the proceeds of the settlements in their income.

The answer, not surprisingly, is that it depends on the facts and circumstances of the case.

As a rule, the proceeds received from most personal injury claims are not taxable under either federal or state law. The IRS does not tax settlement awards if the case demonstrates “observable bodily harm.”

Whether you settled the case before or after filing a personal injury lawsuit in court is irrelevant. A settlement payment may consist of various elements that have been allocated by the parties. These may include allocations to back pay, emotional distress and attorneys’ fees. 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 not taxable. However, you must include in income the portion of the settlement that is for medical expenses you deducted in any prior year(s) – to the extent the deduction provided a tax benefit. If part of the proceeds is for medical expenses you paid in more than one year, you must allocate on a pro rate basis the part of the proceeds for medical expense to each of the years you paid medical expenses.

Proceeds received for emotional distress or mental anguish related to a personal physical injury or sickness are regarded the same as the proceeds receive for physical injuries or sickness. If the proceeds you receive for emotional distress don’t originate from a physical injury or sickness, they must be included in your income.

Punitive damages are always taxable. If you have a punitive damages claim, your lawyer should ask the judge or jury to separate its verdict into compensatory damages and punitive damages. In this way, you can prove to the IRS that part of the verdict was for compensatory damages, which are not taxable.

Note that a portion of the personal injury verdict that IS taxable is interest on the judgment. In most states, the courts add interest to the verdict for the length of time that the case has been pending.