Is my Personal Injury Settlement Taxable?

When is my settlement considered taxable?

The Internal Revenue Service (IRS) will only seek to tax personal injury settlements if the settlement is meant to replace your income. The following are examples of situations when a settlement may be taxed:

When Medical Deductions Have Been Performed:

If you have previously claimed medical expenses your personal injury settlement may be subject to tax.

For example, Bob Smith is injured by a defective lawn mower and has $90,000 in medical expenses. The lawn mower company settles with Bob for $90, 000. The personal injury settlement will be tax-free, and Bob does not need to report it on a tax return. But like most legal matters there are gray areas that come into play. If Bob deducted the $90,000 in medical expenses on a previous tax return, the settlement would be taxable.

Defining the Terms of Emotional Distress and Mental Anguish:

A personal injury settlement with a financial award based partially on emotional distress or mental anguish may be tax-free. If the emotional distress or mental anguish is parallel to the physical injury or physical illness, it is considered “medical” and, therefore, non-taxable.

Let’s modify Bob’s settlement case; Bob again settles with the lawnmower company for $90,000. He received $60,000 for his medical expenses due to a substantial leg surgery. Bob also receives $30,000 in compensation for mental anguish for having to live in a cast for over six months and for dealing with continuous pain. Bob’s $30,000 for mental anguish would likely be non-taxable because it is directly related to his physical injury.

In the circumstance when there is no relation between the emotional distress or mental anguish and a physical injury or physical sickness, the settlement amount is taxable.

For example, lets say you were involved in a dispute with a neighbor because he or she told the neighborhood that you stole money from the local church. These accusations turn out to be completely false, and your local business becomes ruined by your loss of reputation in the community.

You can file a defamation lawsuit against the neighbor and let us pretend your case settles outside of court for $40,000. In this scenario, the entire $40,000 would likely be taxable because you suffered purely emotional and monetary damage.      

Punitive Damages

An injured person may be awarded money that goes beyond ordinary compensation for injuries and is intended to punish the wrongdoer; this monetary award is taxable.

Lost wages or Loss of Income

Similar to wrongful discrimination and defamation, a settlement award with compensation for lost wages or loss of income Is taxable.