Is Your Personal Injury Settlement Subject to Income Tax?
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Will Your Personal Injury Insurance Settlement Be Taxed by the IRS?
By Philip L. Franckel, Esq.
That depends. IRC section 104(a)(2)
addresses income exclusions for taxing personal injury lawsuit settlement
payments. This is a topic on which I can write quite a few pages. However, I
will attempt to give a simpler, general answer here in just a few paragraphs. Of
course, you should not rely on this information and should consult an accountant
or tax professional regarding your specific circumstances before settling your
case or before filing your tax return if you have already signed a release and
settled your case.
Money paid for property damage and medical bills is not taxable because it is
offset by a loss. Likewise, money paid for "pain and suffering" in settlement of
a personal injury claim is generally not taxable because it is compensation for
a loss which is intended to make you whole again.
When is money paid to settle a personal injury
Lost Wages/Lost Income. Money paid for lost income is taxable.
Psychological Injuries. Money paid for
psychological injuries may be taxable. The U.S. Court of Appeals for the
District of Columbia in Murphy and Leveille, Appellants v. IRS and USA,
Appellees, reversed a decision that money paid for psychological injuries is not
taxable. The court ruled that the personal injury award Ms. Murphy received was
"within the reach of the congressional power to tax under Article I, Section 8
of the Constitution", even if the award was "not income within the meaning of
the Sixteenth Amendment". The U.S. Supreme Court denied review of the decision
on April 21, 2008.
Punitive Damages. Money paid for punitive damages is taxable. IRC section 104(a)(2)
was amended in 1996 making punitive damages taxable without regard to their
connection to a physical or nonphysical injury or sickness.
Interest Earned after a Personal Injury Settlement.
If you receive money for an injury which is not taxable and you deposit the
money in a savings account or otherwise invest it, outside of certain kinds of
trusts such as a Special-Needs Trust or Pooled Trust, the interest earned is taxable.
For more information about Special-Needs Trusts or Pooled Trusts, see HelpWithLiens.com.
When money is awarded pursuant to a verdict after trial, the verdict will state
how much money is paid for property damage, medical bills, lost wages, pain and
suffering, etc. The amount of your personal injury award which is subject
to taxation by the IRS or state tax authority will be determined by the jury
The problem is when money is paid pursuant to a settlement,
it is generally not specified in the release what the money is being paid for. It is possible
for the IRS to make a determination by examining various papers in the file,
such as the initial claim letter, the legal complaint, papers submitted to the
insurance company as proof of damages, and the release which was signed.
This problem can be rectified with the proper wording in the settlement release.
The usual "General Release" form is silent on tax issues and thus not helpful.
It is therefore important to customize the release to address the tax issues.
The provisions which result in a favorable tax status are often adverse to the
insurance company's interests, however, I have almost always been able to
successfully include provisions in my clients' release to prevent taxation of
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