A settlement occurs in a legal case when the parties resolve the case outside of court. In a Final Settlement Agreement, the parties will typically waive their rights to pursue any further legal action or monetary recovery from one another in that case. Settlement is encouraged by the courts because it lessens the congestion at courthouses and allows the parties to come up with a mutually beneficial resolution.
A personal injury settlement can be taxable, nontaxable, or partially taxable depending on the type of case and the type of compensation for injuries suffered. The taxable status of a personal injury settlement is often dependent on whether or not there was a "physical injury or physical sickness." The Internal Revenue Service (IRS) has set several broad guidelines, but there is much dispute as to which specific injuries are taxable. Read on to learn more.
Until 1996, most personal injury settlements, whether for physical or emotional injuries, were tax-free. However, current law is more restrictive. Physical injuries and physical sickness are generally non-taxable. For example, Bob Smith is injured by a defective lawn mower and has $90,000 in medical expenses. The lawn mower company settles with Bob for $90,000. The personal injury settlement will be tax-free and Bob does not need to report it on a tax return. But, like most legal areas, there are exceptions. If Bob deducted the $90,000 in medical expenses in a previous tax return, the settlement will be taxable.
A personal injury settlement with a monetary award based partially on emotional distress or mental anguish may be tax-free. If the emotional distress or mental anguish is directly related to a physical injury or physical sickness, it is considered "medical" and, therefore, non-taxable. Let's alter Bob's settlement case a little. Bob again settles with the lawn mower company for $90,000. He received $60,000 for his medical expenses due to extensive leg surgery. Bob also receives $30,000 in compensation for mental anguish for having to live in a cast for over six months and for dealing with daily pain. Bob's $30,000 for mental anguish would likely be non-taxable because it is directly related to his physical injury.
Attorney's fees associated with a monetary award for physical injuries and physical sickness may be non-taxable as well.
The amount received in a personal injury settlement attributed to interest is generally taxable.
As referenced above, compensation received for emotional distress and mental anguish directly related to physical injury or physical sickness can be non-taxable. However, where there is no relation between the emotional distress or mental anguish and a physical injury or physical sickness, the settlement amount is taxable. In this example, Bob is not injured by a lawn mower. Instead, Bob's neighbor tells several people that Bob steals money from the local church. These statements turn out to be completely false and Bob's local hardware business is ruined by his loss of reputation in the community. Bob files a defamation lawsuit against the neighbor and they settle outside of court for $30,000. In this case, the entire $30,000 would likely be taxable because Bob suffered purely emotional and monetary damage.
Other taxable personal injury settlements with non-physical injuries include invasion of privacy, discrimination, harassment, and wrongful termination. Again, because there are no physical injuries, the settlement award is taxable.
An injured person may be awarded money that goes beyond ordinary compensation for injuries and is intended to punish the wrongdoer. This monetary award is called punitive damages. Punitive damages are generally taxable. Subject to limited exceptions, it does not matter if there are physical injuries or physical sickness.
Similar to wrongful discrimination and defamation, a settlement award with compensation for lost wages or loss of income is taxable and must be reported on a tax return.
There are exceptions to almost every legal and tax-related rule. It is advisable to speak with a personal injury lawyer before you accept a personal injury settlement. The lawyer will be able to provide an in-depth analysis of the tax consequences of a specific personal injury settlement, as well as negotiate more favorable terms.