In most cases, the answer is no! Personal injury settlements are usually not taxable under federal or state law regardless of whether you settled the case before it went to trial or won a verdict. Federal tax law specifically excludes damages won as a result of personal physical injuries or physical illness from a taxpayer’s gross income. And all state tax codes reflect the federal tax code’s lead in this matter.
Therefore standard personal injury damages that are meant to compensate the injured party for things like lost wages, attorney’s fees, medical expenses, emotional distress, pain and suffering, loss of consortium, etc. are not taxable as long as they are the result of a personal injury or a physical sickness.
Once a personal injury claim is settled, you’ll be relieved to put the whole incident behind you. But before you forget the matter completely, you should be aware that there are some exceptions to this general rule.
Exceptions to This General Rule
Compensation is taxable if it comes in the form of punitive damages, which are paid by the defendant as punishment for particularly outrageous conduct, and meant to discourage others from similar conduct. If your award in a personal injury lawsuit separates the personal injury damages from the punitive damages, the funds meant to cover the injuries remain tax-free. And even though you have to pay taxes on punitive damage compensation, you are allowed to deduct any attorney’s fees that relate to the punitive amount.
For example, if you are awarded $10,000 for punitive damages, and you have a 1/3rd contingency fee agreement with your attorney, you can deduct $3,333.33 in attorney’s fees relating to the punitive damage.
Next, even if you suffered a physical injury or illness, you will be taxed on damages relating to a breach of contract if it is the breach of contract that ultimately caused your ailments, and if breach of contract is the basis of your lawsuit.
Another element of a personal injury verdict that is taxable is interest on the judgment. Most states have rules that require adding interest to the verdict for the length of time the case has been pending, usually from the date you filed your lawsuit. For example, if you filed your suit on January 2, 2014 and received your settlement amount on January 2, 2016, you would receive 2 years worth of interest, which is taxable.
Keep in mind that a settlement or verdict is non-taxable only if it arose from a physical injury or a physical sickness. If you filed a claim for emotional distress and have no actual physical injury, your award will be taxable.
In order to protect your settlement amount from taxes, work with your attorney to specifically allocate your settlement into two different settlement agreements – one that states the amount for physical injury, and another that states the amount for punitive damages. Setting it up in this way will give you the best chance of having most of your settlement excluded from taxation.