Is A Settlement Considered Income?

After you suffer a loss due to the actions or negligence of another party, you will likely want to seek compensation for those losses by proving that someone else caused your accident and the value of the damage you have sustained. You should hire an attorney to help you file a claim and initiate a lawsuit.

Accident victims who choose to represent themselves in personal injury claims often find themselves fighting an uphill battle. Moreover, insurance companies are unlikely to offer self-represented accident victims a fair value for their claims. Adjusters often assume that these individuals lack the necessary legal experience and knowledge to successfully negotiate a settlement—or take their claim to trial if that becomes necessary in their case.

Fighting for compensation can prove long and tedious, but once you hear the news of a settlement or verdict that benefits you, you will likely feel a burden lifted off you, and you can begin to think about how to move ahead.

As you plan for your future, you must consider whether the settlement you will receive constitutes income and how that can affect your financial planning in the months and years to come. A personal injury lawyer can help you make that determination so you can successfully prepare for the future.

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You May Need to Pay Taxes on Some Insurance Claim or Lawsuit Proceeds

When filing an insurance claim or lawsuit against the parties responsible for your damages, you likely don’t think about whether you will have to pay taxes on the compensation you ultimately receive. However, the tax liability of a settlement can have significant implications on your finances. Failure to understand and prepare for the possible tax consequences of settling a claim or lawsuit can leave you with frustration and a hefty tax bill from the Internal Revenue Service (IRS).

Whether the proceeds of a settlement constitute income will depend on many factors. The laws and rules that apply to settlements can prove quite complex and involved. Various regulations, court cases, and agency rules constitute the discussion of what does and does not constitute taxable income from a settlement.

Does It Matter If Your Proceeds Stem From A Settlement Or Judgment?

As a party to an action seeking compensation, you may wonder whether the stage in which your case resolves will influence whether the proceeds constitute income for tax purposes. A settlement may occur after negotiations outside of court between the parties, and a judgment takes place after a trial and verdict by a court.

Whether your case reaches an out-of-court settlement or a court enters a judgment award in your favor will not change the status of the proceeds. However, a settlement does offer you and your attorneys a say in the allocation of settlement proceeds. A judgment, on the other hand, will depend on how the court allocates the compensation.

The allocation of compensation for your damages can play a role in circumstances where you may have some portion of the compensation that constitutes income while another portion does not. How the judgment or settlement determines the type of compensation can play a part in how much of your settlement or judgment the IRS considers income.

Types of Cases That Do Not Involve Automatically-Taxable Income

The IRS code delineates the sources that fall under the category of gross income. The statutory definition of income covers practically all income sources. Still, some exceptions to this definition exist that will allow an individual to exclude compensation from the year-end calculation of gross income. The Internal Revenue Code specifically makes an exception for the proceeds of a settlement intended to compensate for a physical injury. The theory behind this is that it’s bad public policy to tax an accident victim’s income for the physical and emotional injuries they suffered due to someone else’s negligence.

Accordingly, compensation in cases that arise from personal injuries does not constitute taxable income for the portion of the settlement allocated to the injury itself or the aftermath of an injury. However, certain parts of a personal injury settlement do not qualify under this exception and might still constitute taxable income, depending on the purposes of that particular piece of compensation.

Types of Cases That Involve Taxable Income

A vast number of reasons exist as to why an insurance claim or lawsuit occurs. Personal injury claims constitute just a small portion of the legal matters that can result in a settlement or judgment. For the most part, the IRS considers all other settlements and judgments that include compensation for lost profits as taxable. Some other exceptions and rules can exclude portions of compensation from the classification of taxable income in certain scenarios, but only for very specific circumstances.

Accidents and Injuries that Lead to a Personal Injury Claim or Lawsuit

Before assessing tax liability for personal injury awards, it is important to understand the types of accidents and injuries that may lead to a personal injury claim in the first place.

Some of the most common accidents that lead to personal injury claims include:

• Car accidents where the at-fault driver typically violates a rule of the road, such as speeding, failing to yield the right of way, or making an unsafe lane change. Alternatively, the responsible driver might engage in distracted driving or operate their vehicle under the influence of drugs or alcohol.
• Truck accidents where the operator of a large box truck, big rig, or 18-wheeler violates a rule of the road—or a motor carrier regulation—causing a collision with a much smaller vehicle. In some instances, trucking companies are fully or partially responsible for these accidents, in addition to the truck driver.
• Motorcycle, bicycle, and pedestrian accidents, where a driver negligently strikes an individual while distracted or under the influence of alcohol. When cyclists or pedestrians fall to the ground—or onto another vehicle—they can suffer serious and sometimes permanent injuries, including death.

Any of these accidents may lead to serious injuries requiring extensive medical treatment, surgical procedures, and physical therapy to correct.

Some of the injuries that accident victims suffer and that are legally compensable include:

• Soft tissue injuries, where the accident victim sustains a muscular contusion in the accident, such as a whiplash injury, sprain, or strain.
• Broken bones, where the impact force causes the accident victim to shatter a bone or suffer one or more fractures, including rib fractures. These injuries often require prompt medical treatment, including a surgical procedure and physical therapy.
• Internal organ damage, where the impact force causes the accident victim to suffer internal bleeding or damage to their internal organs, causing other health complications.
• Traumatic head or brain injuries, including concussions, where the impact force causes an accident victim’s brain to move around inside their skull, striking the side of the skull and causing a bruise. Accident victims who suffer traumatic brain injuries may experience short- and long-term symptoms. Potential short-term symptoms include memory deficiencies, headaches, fatigue, nausea, and dizziness. However, some accident victims experience long-term TBI symptoms, including permanent memory loss, inability to care for themselves, or a permanent coma.
• Road rash and other scrape/burn injuries that require stitches and sometimes leave unsightly scarring on the accident victim’s body

If you suffered any of these injuries in an accident that resulted from someone else’s negligence, your first step should be to seek immediate medical treatment at a local urgent care center or hospital emergency room. Your next call should be to a knowledgeable personal injury lawyer.

Your attorney can begin handling the legal aspects of your claim while you focus your complete attention on getting better. After you finish your medical treatment, your lawyer can file a personal injury claim or lawsuit on your behalf and help you recover the full amount of damages you deserve.

What Damages Make up a Personal Injury Settlement?

Each personal injury claim or lawsuit will tabulate the damages a victim sustains. The calculation of damages can affect the classification of compensation as income. In a personal injury case, the IRS does not consider any compensation directly from your physical injuries as taxable income. However, some damages may not fall under the income exception, particularly those damages that do not directly relate or tie to your physical injuries.

Economic Damages

Medical expenses. The portion of your settlement intended to cover medical costs does not constitute taxable income in general. Medical costs in a personal injury matter may include doctor bills, surgical costs, and physical therapy expenses.

However, if a victim has taken a deduction in the prior year’s tax returns for certain portions of the settlement or judgment, that amount must count as income. For example, if you made payments for your medical expenses and bills and then took an itemized deduction of that amount on your tax return at any time, you cannot also exclude that amount from your settlement as taxable income.

Lost wages. In other non-injury-related settlements, the IRS will frequently tax the compensation received. Just as you receive a tax bill on your earned income, the IRS will also tax any replacement of that income. The IRS, however, makes a specific exception to recovering lost wages and other income losses in personal injury cases. The IRS won’t tax any compensation for loss of income related to a physical injury.

Accident victims are eligible for lost wage compensation if they can prove that a medical provider authorized them to be off work for a certain period due to their injuries. Moreover, the accident victim must usually introduce documentation from their employer which shows the number of work days they missed and the amount of money they lost per day. Finally, they may need to produce copies of recent tax returns to prove their lost wage claim.

Non-Economic Damages

Pain and suffering. The IRS code can prove confusing concerning the settlement classification of income. Injured individuals often receive compensation for past and future pain and suffering, also known as emotional distress, in their personal injury claims. The recovery of this non-economic damage often goes hand in hand with the injuries a victim of a personal injury accident sustains.

If a physical injury directly causes the emotional distress of a victim, the amount of the settlement for pain and suffering won’t constitute taxable income. However, the distinction of whether compensation relates to a physical injury will prove critical if you wish to exclude that portion of settlement from income.

If the emotional distress stands alone as its own claim or has no relation to a physical injury but rather just an event or action of the other party, then the IRS will consider those proceeds as income for tax purposes.

Proving that past/future physical pain and suffering relate to an injury often requires medical testimony. For example, a treating healthcare provider can state in writing—or at a deposition or jury trial—that the accident victim’s physical complaints relate to the injuries they suffered in their accident. The medical provider must also state this opinion to a reasonable degree of medical certainty.

In addition to establishing this causal connection between pain/suffering symptoms and accident-related injuries, the medical provider may establish that the injury-related symptoms are permanent and will likely cause the accident victim to suffer pain for the rest of their life.

Punitive Damages

Courts award punitive damages to punish wrongdoers in a case for particularly egregious conduct, not to compensate victims for their injuries.

Another purpose of punitive damages is to dissuade others from committing similar wrongful acts. As such, the IRS will always consider the portion of a settlement for punitive damages as taxable income. Courts rarely award punitive damages, and as a result, most judgments don’t include punitive damages. Furthermore, since courts must award punitive damages, only a court verdict will include them, not a settlement agreement between the parties.

Some of the highest judgments in a personal injury case can include punitive damages. When a court perceives extreme malice or misconduct by a defendant, punitive damages can reach very high levels. For example, in a motor vehicle accident arising from drunk driving, the court or jury may impose punitive damages against the intoxicated driver.

In some situations, the punitive damages award can far surpass the total economic and non-economic damages. When this happens, the punitive damages may constitute a considerable amount of the final judgment. Due to the tax implications of the IRS code that pertains to this portion of a judgment, a plaintiff may bear liability for a significant amount of taxes on this money. Punitive damages can create complications for a plaintiff who may not realize that the money constitutes taxable income and can face challenges down the line with the IRS without proper tax planning.

Interest

While not all settlements and judgments will include interest, if a portion of the award does indeed include interest, then that amount constitutes taxable income for tax purposes.

Can a Confidential Settlement Affect Your Tax Liability?

Plaintiffs in a case may wonder whether a defendant’s insistence on a confidential settlement can affect the amount of taxes they must pay. The answer is: it might. While the compensation for losses related to your injury will still fall under the exclusion of income by the IRS for damages that stem from physical injury, a confidential designation may have some tax implications.

The IRS may perceive that the plaintiff has received additional compensation from the defendant to keep the terms and facts confidential. If so, and the defendant includes additional money solely to gain a confidentiality agreement, the IRS will tax the extra compensation for this agreement.

What Should You Do to Protect Yourself if You Anticipate a Settlement?

While the thought of figuring out and paying taxes on a settlement can prove overwhelming, you shouldn’t panic. With some forethought and proper planning, you can take steps to protect yourself to ensure that you won’t bear responsibility for more taxes than you must pay after a settlement or judgment.

Once you have completed the negotiation of a settlement or a trial, you should begin to consider your next steps. You should consult your attorney and a knowledgeable tax planner as soon as possible to avoid getting caught off guard if certain portions of your settlement constitute taxable income.

Contact an Experienced Personal Injury Attorney

While your attorney likely doesn’t have special tax knowledge, nor are they responsible for the tax liability of your settlement or judgment, experienced attorneys have some influence on the allocation of damages for your case. The IRS doesn’t have to follow or abide by how your attorney ultimately calculates the damages in your settlement. However, if you have the evidence and documentation to support a calculation, the IRS will look at that to determine whether the compensation qualifies as income—and whether or not you will owe taxes.

Your attorney will help determine the tax liability of your compensation by negotiating your settlement and calculating your damages. Your attorney can help ensure that you avoid haphazardly classifying your compensation and instead ensure the careful allocation of each amount of damages to the correct category of loss. The more organized and clear your settlement calculation, the more likely the IRS will follow your lawyer’s categorizations.

Consult a Tax Planner

After you receive the details of a settlement or judgment, you should immediately contact a financial and tax planner who can assist you in making the best decisions for you and your interests. A tax professional can help you better understand the ramifications of a settlement and properly prepare to make tax payments if necessary. Once you finally reach the point in your case where a positive resolution is within reach, you must also protect your future and finances. Failure to plan properly after a settlement or judgment can lead to complications down the line and trouble with the IRS.

If you or a family member sustains injuries in an accident that you believe another party’s negligent or reckless actions caused, you may qualify to pursue compensation under the law. Contact a personal injury lawyer for a free evaluation of your case.

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