Do you pay taxes on personal injury settlements? Settlements and awards for personal injury cases can take a long time, often leaving you in emotional and financial hardship. If you win a personal injury case and get compensation, you’ll probably want all the money you deserve after paying your attorney. But you might be wondering if you’ll owe taxes to the government on your settlement.
Most of your settlement or award typically won’t be taxed, but some parts might be. You could receive different types of damages. The Los Angeles personal injury attorney at Tenina Law has some important info for you about this.
Understanding State and Federal Taxation
California residents earning over a certain threshold must submit income taxes to both the California Franchise Tax Board and Internal Revenue Service (IRS), unlike states such as Oregon which do not levy state income taxes but instead implement higher sales taxes; California requires paying both sets of income taxes.
Not all forms of income are subject to taxes; state and federal rules vary accordingly. The California Franchise Tax Board usually considers income taxable if the IRS sees it as taxable. This applies to parts of an award or settlement for personal injury. Here are some common questions about how different types of damages are taxed.
Do You Have to Report a Personal Injury Settlement on Your Taxes?
The IRS is known for taxing most types of income, even things like gambling winnings or reporting a bank robbery. Personal injury settlements usually don’t need to be included on your tax return, although in certain instances taxes might still apply.
Injury or illness settlement money is usually exempt from taxes. So if you receive one but did not itemize medical expenses as tax deductions, no need to include it when filing taxes.
But there are exceptions:
If you deduct medical costs on Form 1040, that portion should now count toward your taxable income. If your settlement payments were spread across more than one calendar year, each portion received will incur taxes accordingly.
So, while personal injury settlements are often tax-free, it’s essential to consider these exceptions in specific situations.
Past and Future Medical Expenses
According to 26 U.S. Code § 104(a)(2), compensation for medical expenses related to physical injuries is exempt from your gross earnings and generally not subject to taxation by both the IRS and California. This exemption covers damages for both past and future medical costs. These damages are considered reimbursements for the money you’ve spent on treating your injuries, including future expenses.
But if you claimed itemized deductions for certain medical expenses while your lawsuit was ongoing, according to 26 U.S.C SS 104(a), these must also be included on your tax return when filing it. This rule states that medical expenses itemized during their year of incurrence cannot be excluded from gross income when receiving verdict or settlement awards.
You won’t need to report medical expenses beyond those you’ve claimed as itemized deductions. If you didn’t itemize medical expenses and instead used the standard deduction, none of your settlement or award for medical expenses will be subject to taxation.
Past and Future Lost Wages
You can exclude most medical expense compensation, but this rule doesn’t cover lost wages. This includes money for the work you missed in the past when you couldn’t work and money for future earnings if your disability is permanent. These payments aim to replace the income you would have earned, which would have been taxed. Both the IRS and California consider these payments taxable, so you must report them. This part of your settlement is typically the largest and most important to report.
In your personal injury settlement, you might get money to cover property damage. For example, if you had a car accident, your settlement could help fix or replace your vehicle. Usually, you don’t have to pay taxes on property loss damages.
However, there’s one exception: if the extra money you receive goes beyond what your property is worth, that extra part is taxable.
Depending on your injury, you might also get compensation for property damage. This often happens in auto accidents. These payments are meant to cover the costs of fixing or replacing your damaged property, like your vehicle. They’re not taxed, and you don’t have to report them.
But if you receive money because your property’s value has decreased, you should report the difference between what you get and the property’s actual worth. For instance, if your car is worth $20,000 and you get $25,000, you’d report the extra $5,000.
Pain and Suffering
In most personal injury settlements, you’ll find something called “pain and suffering” damages. They provide compensation for the non-economic impacts of injuries such as physical pain or emotional distress. Fortunately, physical pain and discomfort compensation are non-taxable – no reporting to either California or the IRS is required!
Assuming you experienced emotional pain and suffering because of physical injuries, that money won’t be subject to taxes. However, if it were received solely from emotional sources without physical damage being present then that amount may be subject to federal and state taxes. Though most personal injury claims involve physical injuries most likely these emotional pain and suffering damages won’t require taxes to be reported and paid back out.
If your mental anguish isn’t linked to a physical injury or illness, your settlement will be taxable under Section 104(a). But there are ways to reduce the taxes you owe:
- Deduct any medical expenses related to your mental distress that you paid but didn’t previously deduct.
- If you didn’t get a tax benefit from deducting medical expenses before, you can deduct them now for your mental distress.
When reporting compensation for pain and suffering, include a statement with your tax return. This statement should detail your total settlement amount, minus any medical expenses you haven’t deducted or those for which you didn’t receive a tax benefit.
Punitive Damages or Interest
If you’ve been hurt in an accident where someone intentionally caused harm or showed extreme negligence, you might receive something called punitive damages. These damages are not meant to compensate you for your injuries but to punish the person at fault. It’s important to know that punitive damages can be taxed, so when you report them on your tax return, classify them as “other income.”
Before your case is settled, it’s crucial to understand how much of your personal injury settlement falls into each category. This will help you figure out if your settlement is subject to taxes. If you’re uncertain about these details, consider consulting your attorney or reaching out to the IRS for guidance.
Punitive damages are usually awarded in specific personal injury cases, and they are added to compensatory damages, which cover economic and non-economic losses. These damages come into play when the defendant’s actions are particularly outrageous and are meant to serve as a punishment. In some cases, the court may also order the defendant to pay interest.
You should be aware that you’ll need to pay taxes on both punitive damages and any interest you receive. However, it’s important to note that interest related to prejudgment cannot be applied to non-economic damages.
So, if you receive punitive damages, it’s essential to report them on your tax returns and be prepared to pay the taxes on them. The severity of the defendant’s actions in your case determines whether punitive damages are awarded or not.
How Do You Calculate the Amount of Damages Awarded for Each Category of Damages?
It’s crucial to give a thorough and accurate breakdown of your damages. Different parts of your settlement or award might have different tax rules. Your personal injury lawyer will ask for a detailed breakdown of all your damages. They’ll also want to know if your lawsuit involved any extra claims apart from your personal injury claim.
Contact a Los Angeles Experienced Personal Injury Attorney
The state and IRS can only claim a small part of your total award or settlement for a personal injury case because a significant portion of it is not taxable. Once you’ve paid your attorney’s fees and legal costs from your award or settlement, you get to keep the rest, except for any taxes you owe on damages related to lost wages, punitive damages, or interest.
If your claim is successful, you should receive enough money to cover your recovery expenses. If you want more information about your case or your rights, you can contact Tenina Law at (213) 596-0265.