Personal injury cases are sensitive since they decide upon the compensation that a plaintiff deserves for suffering an injury. These injuries are often some of the most critical setbacks a person can face in their life. A successful personal injury case either ends up in an award of damages or a settlement being reached between the parties. There are a lot of factors that need to be considered during the course of negotiations in a settlement and after securing it. Tax liability and the effect of applying taxation upon the amounts decided is one such factor and is necessary to be determined.
Personal Injury Settlements: Taxable or Not?
Do proceeds from such settlements fall within the ambit of taxable incomes? The answer to these questions cannot be a one-liner statement declaring whether settlements taxable or not. Instead, we would have to probe into the US’s complex taxation regime and see what elements make an amount taxable by the federal and state governments.
A settlement amount is reached to provide the plaintiff with ample compensation for the injuries sustained by him. In return, the plaintiff is required to withdraw their personal injury case from the court. These compensations are an inflow of money and can be taxed depending upon the purpose they serve. Hence, different forms of payments attract various tax liabilities applicable to them. Plaintiffs having sustained personal injuries mostly seek compensation for a few frequently mentioned purposes. These could either be the medical bills and treatment the plaintiff has paid or are required to be paid, the pain and suffering underwent, psychological harm and distress, loss of wages and incomes due to the injury, or other types of damages. We will discuss the tax liability that each of these compensatory purposes attracts.
Treatment of personal injuries entails hefty medical bills. Medical expenditures are demanded to be covered by plaintiffs to make right the physical injuries and impairments suffered. Given this, plaintiffs are required to demonstrate the quantum of medical expenditures that have been and are likely to be incurred before the court. If granted, the compensation covers the medical costs completely. Hence, nothing from this award acts as a possible income or supplementary earning. For this very reason, compensation to cover medical expenses is exempted from tax liability.
Emotional Anguish and Pain and Suffering
Compensatory damages secured on account of emotional distress and suffering can and cannot be taxable: bipartite approach. Under the law, if the emotional anguish, pain, or suffering is sustained due to a personal injury, i.e., physical damage to a person’s body, then amounts recovered due to such distress are exempt from all taxation.
However, the emotional harm is suffered due to injuries not involving personal damage, monetary claims for such penalties will incur a tax liability. Anguish and agony arising out of property damage or defamation will be subject to the relevant taxes. If, where, it can be shown that a specific part of the monies recovered on account of emotional harm was spent for recovery of mental health and to look after the psychological well-being of the plaintiff, that specific chunk of income can be deducted from the total taxable amounts received.
Loss of income, business opportunity, and wages are overall taxable. It is also required to be reported with the relevant departments under the applicable laws. Compensation on account of lost wages is taken as wages earned, which falls under taxable incomes.
Compensation claimed and received on account of property damage suffered by the plaintiff are excluded from taxation. This runs upon the same principle as in medical bills: the proceeds generated will be granted with the supposition to be utilized for making good the actual loss. In this manner, no part of the proceeds can be taken to be an income or revenue as such, hence not taxable.
Moreover, property damage often harms the overall valuation of the property. Since the compensation is awarded or is settled to be paid to restore the property value back to its previous position, it is not taxable. However, suppose the amount received in compensation is greater than how much the property had devalued. In that case, the difference may be taxable as capital gains.
Consequential & Interest Income
After the injuries, be it physical or emotional, have been made right through appropriate care and treatment, the plaintiff must utilize the amount as he wishes. If the plaintiff decides to invest such an amount to his eventual gain in the years to come, he may do so. However, no exception from paying taxes would play here when such an investment starts giving off profits. Whether in the form of profits or interest, the incomes generated will incur tax liability due to be paid.
Punitive damages are awarded by the courts, not with the motive to provide plaintiffs with relief, but rather to punish and discourage similar conduct by the defendant and others in the future. Hence, punitive damages are not treated as compensation but as bonus income and are taxable no matter what under all tax regimes, whether federal or by the state. Even the principal purpose of such payment is disregarded when it comes to punitive damages, those damages secured under emotional stress or personal injuries incur taxation liability.
In cases where these compensations are secured not by way of a settlement but instead obtained through a jury award, the application of taxes remains unchanged. This is because the US tax laws treat proceeds generated from settlements and jury awards alike for all purposes. Hence, you can work along with your attorney or a tax professional to help you find ways to minimize your tax liability. This is called tax avoidance, which is entirely legal in most jurisdictions of the world. You can structure a plan that stretches your settlement payment over a more extended period, sometimes many years, to keep the applicable tax rate as lower as possible.