November 18, 2013

(Credit:  401(K) 2013)

(Credit: 401(K) 2013)

Today’s blog post discusses tax laws and The Cochran Firm, D.C. does not provide tax advice. Before making any decision regarding your tax liability, we strongly recommend speaking with a qualified tax attorney.

Proceeds received from a personal injury lawsuit can sometimes be very substantial. A common question we encounter at The Cochran Firm, D.C., is whether this award is taxable. In most circumstances, the portion of your personal injury award attributable to your injury is not taxable.

If the settlement or award is meant to cover costs caused by your injury, those costs are not taxable under 26 USC § 104(a)(2). Hospital and legal bills fall under this category. Whether the amount was received through an out-of-court settlement or a jury award does not affect the taxability of the recovery.

How personal injury/physical sickness awards and settlements are taxed

If you did not take an itemized deduction for medical expenses associated with your injury, the full amount of your personal injury settlement or award is non-taxable. If you previously deducted medical expenses for costs that were later reimbursed by a settlement or award, however, you must include the reimbursed amount as part of your taxable income. This rule is meant to prevent double dipping. For more in-depth treatment, see IRS Revenue Ruling 75-230. We rarely, if ever, see this situation with our clients.

In general, settlements and awards for mental anguish and emotional distress caused by your injury are treated the same as personal injury or sickness awards. If you receive an award for emotional distress and mental anguish that was not caused by personal injury or physical sickness, that amount is taxable. However, you can reduce that taxable amount in two ways:

  1. Medical expenses for anguish and distress that were not previously deducted; and
  2. Previously deducted medical expenses for anguish and distress that did not provide a tax benefit.

If part of your out-of-court settlement or personal injury award is determined to be interest accumulated since the injury and the date of payment, this portion of the award is taxable. The portion of an award or settlement attributable to punitive damages is also treated as taxable income.

If you received money from your employer for working, this amount would obviously be considered taxable. But interestingly, the portion of awards and settlements for lost wages in personal injury cases is generally not taxable. Your accountant or lawyer will need to research the local rules that apply to you, but generally this is the case. The federal government does not treat personal injury awards as if an injured victim has won the lottery, but instead sensibly treats them as if the injured individual has been made whole again.