In honor of tax season, here is a brief reminder about the potential tax implications of personal injury settlements. Conventional wisdom is that recovery for personal injury claims is not taxable income, except for punitive damages. However, it is important to remember that this is not always the case. Most of us are not tax experts, but a general understanding of how different types of damage are treated is essential when a client asks about the tax implications of a settlement. Here is a general breakdown of the taxability of typical categories of damage in a personal injury case.
- Physical Injury / Physical Illness. As a general rule, recoveries arising out of personal injuries / sickness are not taxable. However, there may be some tax liability if the recipient took itemized deductions for related medical expenses for which they subsequently received payment.
- Emotional Injury / Emotional Distress.
- Settlement proceeds stemming from emotional distress related to an underlying physical injury or illness, are generally not taxable; but
- In the absence of an underlying physical injury or illness, damages arising out of a purely emotional injury with no underlying physical injury generally are taxable.
- Punitive Damages. Punitive damages are taxable as “Other Income.”
- Pre & Post Judgment Interest. Interest that accrues on a personal injury claim after filing suit and before the verdict is paid in full is considered taxable income.
In some instances, there may be advantages to allocating the recovery into specific categories of damages in a settlement agreement. Generally, the IRS will recognize the allocation of proceeds to specific categories of damages within a settlement agreement, as long as it is consistent with the substance of the claims. But the IRS can override the allocation if it is determined to be unreasonable so don’t try to get too creative. IRS Bulletin 4345 (9-2023) provides a helpful summary of the IRS’ current position regarding settlements / verdicts.
The most important takeaway is that taxation of legal recoveries can be more complicated than you think and it is in both the attorneys’ and the clients’ best interest to encourage clients to seek professional tax and accounting advice when filing taxes after resolving a personal injury claim.
Berman & Simmons, P.A. does not provide tax or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax or accounting advice. Consult a tax and accounting advisor about the tax implications of specific settlements.