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How the Tax Code Treats Personal Injury Settlements

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In this lesson, we will discuss when a personal injury settlement is exempt from taxes and under what circumstances a settlement is fully or partially taxable.

Personal Injury Settlements

Joe was recently injured in a vehicle accident that was caused by a drunk driver. Personal injury cases can involve a significant amount of losses for the injured party. When Joe got hit by a car he had to miss work for a few days and incurred a number of medical expenses. The driver's insurance policy wants to make a cash settlement rather than let the court award damages. Joe agreed, but is now curious about the tax consequences of his decision. Would he be better off letting the judge decide? Let's help Joe understand the tax implications of a personal injury settlement.

Tax Treatment

A personal injury settlement occurs when the physically injured and injuring parties agree to a specific amount of monetary compensation outside of a trial. In most situations, personal injury cases are settled before or while the case is in court.

The Internal Revenue Service does not collect taxes on settlement funds that are related to a physical injury or illness. This exclusion doesn't just apply to money that covers medical expenses. Settlement income that covers lost pay, emotional distress, pain and suffering, or legal fees are also not subject to tax. If the court awards damages at trial, the payments are also not taxed. The individual states do not generally tax personal injury settlements either, but in all cases it would be a very good idea to consult with an independent tax attorney.

Exceptions

There are a few major exceptions to personal injury settlements generally not being taxable. The first exception includes situations where a breach of contract has occurred. Let's say Joe was injured because a car rental company rented him a car with defective seatbelts. Because the lawsuit against the rental agency would be based on a breach of contract, any proceeds Joe receives would be taxable.

If the case were to go to court, any punitive damages would also be considered taxable income. Since punitive damages are intended to have a punishment effect for the guilty rather than compensate the victim for losses, the money is taxable. If this happened, Joe's attorney would ask the judge or jury to define which portion of the award is punitive and which is compensatory so that Joe avoids paying taxes he legally doesn't owe.

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