When it comes to personal injury claims, it isn’t surprising to find that most are settled out of court before or during the trial. Once you have accepted the settlement offer from the other party and signed a release, the case is considered closed.
After receiving the amount, as a personal injury claimant, you will have several things to consider. What comes next? Can you keep the entire amount received (excluding the attorney’s fees)? Do you owe anything to the IRS?
In general, it is always advised to prioritize non-taxable objectives over taxable ones. To do this successfully, you need to understand the consequences of your decision in terms of taxes. This is the best way to ensure that you can obtain the tax benefits available to you.
Let’s take a look at some important income tax considerations in a personal injury settlement.
Compensation for Physical Injury
Typically, the amount received in a personal injury settlement is not taxable under the federal or state law. Whether you settled the case before or after filing a personal injury lawsuit in court will not impact this outcome either. As per personal injury law, even if you went to trial and won the settlement, the amount received will still be non-taxable.
Neither the federal government (the IRS) not the state government can tax your settlement amount or the proceeds in the majority of personal injury cases.
The federal law tax excludes compensation received due to personal physical injuries or physical sickness from your income. A physical sickness refers to a claim for an illness. For instance, if you were carelessly exposed to a virus that made you physically unwell, you can be eligible for compensation. Any damages you receive due to the illness will not be taxable.
In other words, personal injury damages that are supposed to compensate for factors such as medical bills, lost wages, pain and suffering, emotional distress, loss of consortium, and lawyer payments are not taxable as long as they arise due to personal injury or physical sickness.
There Are Always Exceptions
Having said that, if you suffer a physical injury or a physical illness, you may be taxed on damages related to breach of contract. This means that you will have to pay taxes on the settlement received if the breach of contract was the foundation of your lawsuit, and the breach caused your injury.
Other than this, punitive damages are also taxable. In the case of the punitive damages claim, your lawyer will ask the judge to separate the verdict into compensatory and punitive damages. This arrangement will enable you to show to the IRS that a certain portion of the verdict is compensatory damages and should not be taxable.
Another taxable element in the personal injury verdict is interest on the judgement. In most states, the court adds interest to the verdict for the duration of time that the case was pending.
If you filed your lawsuit on January 1, 2020, for instance, you should receive interest on the verdict starting from that date itself. The interest continues to run until you receive the settlement amount. If you win the trial on January 10, 2021, but the defendant challenges the verdict and does not pay you until March 31, 2022, you will be eligible to receive interest worth of two years and three months. The interest is paid on the amount of the unpaid verdict, and is taxable.
As mentioned, the settlement is non-taxable only when it is received due to a physical injury or physical sickness. If you have a claim for emotional distress or workplace harassment/discrimination, but no actual physical injury to show, then your settlement will be taxable.
In fact, if the proceeds from emotional distress do not arise from a physical injury, they may have to be reported as “other income.”
You will need to prove that you have suffered a physical injury, even the slightest, to make the settlement non-taxable.
Factors to Consider When Filing Taxes after Settling
If you’re still confused about owing taxes on your personal injury settlement, here are a few pointers to bear in mind.
- Lost wages: This aspect comes into play in employment-related settlements. If you have been compensated for involuntary termination or discrimination, the settlement will likely be taxable as it will not be considered a personal injury.
- Interest: Any amount received as interest on any settlement income is taxable.
- Loss-in-value of property: Property settlement for loss in the value of property is usually non-taxable if it is lower than the adjusted basis of your property. If it is greater, the surplus amount is taxable.
- Health Insurance Marketplace: If there is an increase in your income due to punitive damages, do inform the Marketplace about it to help them understand your tax liability.
Ensuring Non-Taxability of Settlement
In some cases, you may have two claims against the defendant, and only one of them might be related to personal injury. In this situation, you may want to clearly state in the settlement agreement how much amount relates to the personal injury claim and how much to the other claim. This should be ensured if your personal injury claim is higher than the non-personal injury claim.
For example, it is not uncommon for an injury to result in both a negligence lawsuit and a breach of contract claim. In these situations, the taxability of the two different settlements are very different. The bulk of your personal injury case will not be considered income, but the same is likely untrue for a breach of contract lawsuit. That is the case even if the breach of contract involved a bodily injury of some kind.
In these cases, the guidance of a personal injury lawyer is invaluable. Your attorney can help clearly delineate which aspects of your settlement are related to a personal injury case, and which aspects are not. This clear and specific allocation of the settlement amount will let the IRS know about what is and isn’t taxable in the settlement, should they challenge the verdict.
How Does the IRS Collect Taxes on Settlements?
In the rare cases where the results from a personal injury lawsuit are taxable, the IRS collects those taxes just like with any other type of income. That means you are required to report this income to the IRS each year during your standard tax return filings.
It is only necessary to report the aspects of your settlement that are treated as taxable income. In other words, the proceeds from your settlement that are directly related to your bodily injuries do not need to be reported to the IRS at all.
The same is not true when it comes to the portions of your settlement that are taxable. If you have recovered punitive damages or interest on your judgment, it is necessary to report that income in the appropriate year.
Once you have reported these proceeds, they are treated just like any other income. That means two people could face very different tax bills for their personal injury lawsuits, even when the amounts are similar. Ultimately, your tax bracket and the amount of your settlement will play an important role in determining what your final tax liability is.
The extent of your tax liability will also come down to the way that your settlement is negotiated, written, and executed. That makes your choice of a personal injury lawyer a vital one. Your attorney has the power to carefully negotiate the terms of your settlement to ensure you are not unfairly taxed on what should be exempt personal injury lawsuit proceeds.
Settlements vs. Trial Verdicts
Whether you conclude your case with a settlement or secure a verdict a trial, the potential for facing tax obligations is no different. While the nature of your compensation is not an issues, it is important to note that there could be challenges that present themselves with trial verdicts that differ from settlements.
When you settle your case, you and your personal injury lawyer have an opportunity to draft the terms of the agreement. This is useful, as the terms of this document could make it clear to the IRS what the nature of your compensation is.
When you prevail at trial, the court is often responsible for issuing the order in your favor. It might not contain the same amount of detail that a settlement agreement does, which could make it harder to establish what you were compensated for.
How a Hawaii Personal Injury Lawyer Can Help
An experienced lawyer has dealt with every aspect of personal injury cases and knows how the IRS works with respect to taxing settlements. Having a good personal injury lawyer in your corner will ensure that your rights and interests are always protected.
They can also negotiate a suitable settlement for your injuries. Additionally, they can efficiently resolve your queries about how your personal injury settlement can be subjected to taxes in Hawaii.
Call Personal Injury Attorneys at Olson & Sons Today!
In the end, the answer to the question of “is my personal injury settlement taxable” is “it depends.” Most of the time, you will not face a tax obligation based on your personal injury lawsuit proceeds. As is the case with most legal issues, there are also exceptions that might apply to you.
Dealing with a personal injury lawsuit is stressful, and that is before possible tax liability becomes an issue. When you work with a skilled personal injury lawyer from Olson & Sons, you could ease your concerns about possibly facing a large and unexpected tax bill after you settle your case.
Handling legal matters in Hawaii can get complex, especially when financials comes into the picture. This is why working with a seasoned Hawaii personal injury lawyer makes perfect sense. Hopefully, the above information will help you understand what is and isn’t taxable as far as your personal injury settlement amount is concerned. For further clarity, it is always recommended to get in touch with a competent personal injury attorney. Reach us at (808) 745-1565
