- Nov 20, 2022
Updated: Dec 26, 2022
Any portion of a personal injury settlement or judgment that is paid for physical injuries or sickness is not taxable. But there are some important exceptions to this rule.
One of the most important questions clients often ask is whether the money they receive from their personal injury case is subject to local, state and federal taxation. The answer to this question may seem simple, but most often requires an analysis of the facts to determine how the settlement funds have been categorized or allocated.
General Rule: Payments for Physical Injuries or Sickness are Not Taxable
Generally, any settlement money that is designed to compensate an accident victim for physical injuries or sickness is not taxable by the IRS or the state of California.
Additionally, any settlement paid for a loss in the value of the property that is less than the cost of that property is not taxable. But the recipient must adjust the cost basis of the damaged property by the amount received in the settlement.
For example, an accident victim receives a $1,000 settlement as a result of her injuries sustained in a car crash; none of that $1,000 is taxable. Some other examples of personal injury cases where settlements are generally excluded from being taxed are: dog bite, slip and fall, medical malpractice, defective product, wrongful death, hit and run, motorcycle and bike injuries. However, there are a number of exceptions to this general rule which are discussed below.
Exception 1: Any Itemized Deductions for Medical Expenses are Taxable
If an injured person took an itemized deduction for any medical expenses associated with a personal injury and was later reimbursed for it, the amount that was reimbursed is subject to state and federal taxation.
Exception 2: Punitive Damages are Taxable
In some cases courts award an injured party punitive damages in addition to compensatory damages. Punitive damages are designed to punish the defendant in situations where the court deems the behavior to be intentional or done with a complete reckless disregard of the public’s safety. For example, reckless driving due to texting or driving while under the influence may subject a defendant to punitive damages. Accordingly, punitive damages are taxable even if they were received for personal physical injuries or sickness.
Exception 3: Defamation Damages are Taxable
Damages awards received in defamation cases are taxable because the IRS has determined that they do not arise from physical injuries or sickness.
Exception 4: Emotional Distress Damages are Taxable
Similarly, any settlement money received as a result of an emotional distress or mental anguish that does not arise from a personal physical injury or sickness, such as a vehicle collision or a dog bite, is taxable. However, if the emotional distress is directly related to the personal injury suffered as a result of the accident, then those settlement funds are not taxed.
Exception 5: Interest on a Settlement is Taxable
Whenever a judgment or a settlement includes interest payment, those interest payments are taxable even if the principal amount is not. For example, if a vehicle accident plaintiff receives $1,000 in payment for physical injuries and $50 in interest, only the $50 is subject to federal and state taxes.
Exception 6: Lost Wages are Taxable
Settlements that are paid to compensate a victim for lost wages are taxable under California and federal law. These payments are essentially aimed at compensating a person for the loss of wages or earnings and as such are always taxable.
Lost wages damages usually arise in employment-related cases and include such things as actual lost wages, back pay, overtime pay, sick pay, tips, severance pay, bonuses, fringe benefits, or any other type of compensation which would normally be subject to taxes.
Exception 7: Lost Profits are Taxable
Similar to lost wages, damages for lost profit arising in a trade or business is considered net earnings and are taxable. These damages are designed to reimburse the plaintiff for the profit that would have been earned had the injury not occurred, thus subject to taxation both at the federal and state level.
Exception 8: Damages in Excess of a Property’s Cost are Taxable
If a settlement for property damages, such as a car, exceeds the adjusted cost of the property, then the excess is taxable.
If you have been involved in a vehicle collision or any other type of personal injury in Los Angeles, you should contact an attorney to determine what your damages are.
DISCLAIMER: The above article is not tax, legal, or accounting advice. The article is provided for informational purposes only. Tax laws are complex and your situation may be different than the facts described in this article. Please consult with your tax consultant, CPA, or attorney if you need advice regarding your tax situation. Do not rely on the information contained in this article.
