Personal Injury Settlements Are Mostly Not Taxable
Is your personal injury settlement taxable? Compensation for your actual physical injury is not taxable. There are a few clarifications that are listed in IRS Publication 4345 and we will go through those in detail.
Prior Medical Expenses Claimed on Schedule A
The IRS says whatever prior tax benefit you received from deducting the medical expenses should now be considered as income. Here is an example. In 2015 you add $15,000 in medical expenses to your Schedule A. This saved you $8,000 in taxes. Your personal injury settlement that covers the $15,000 in medical expenses has been received. For the current year in which you receive the settlement you should record $8,000 in income.
Damages received for emotional distress or mental anguish that is a direct result of the physical injury are not taxable. If you receive damages for emotional distress or mental anguish that is not tied to a physical injury then it is taxable.
Deducting Emotional Distress Expenses
Even if your emotional distress or mental anguish damages are taxable, you can subtract from the total:
(1) amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.
The IRS is going to want you to attach a statement showing how much was received from the settlement as well as the expenses incurred. It is recommended to have a tax professional prepare this for you with your tax return. We do not recommend self-preparing tax returns especially in a year where this issue may come up.
Mixed Claims: When You Receive More Than Just Personal Injury Damages
Often there are personal injury cases that also involve a contractual or other type of claim. On these the IRS is seeking what type of net gain you are receiving to determine if it is taxable. If you have taxable damages, you may need to make estimated tax payments. The actual injury portion and related expenses of these damages is not taxable. In any of the below instances, it is recommended to have a qualified tax professionals assist you. Preparing taxes incorrectly could result in penalties and interest added at a later date.
Wages and Lost Profits
If you receive compensation for wages or lost profits in a business, they would be taxable. It is taxable because it is treated as if it was actual wages or lost profits, which are taxable.
If you receive personal injury damages that also include property loss, it is not taxable to the extent of your cost basis. If you received more than the cost basis for your property, it is taxable.
Any interest paid on any damages is taxable.
Amounts received for punitive damages are taxable.
If you are not sure if your personal injury settlement is taxable, look to whether the damages are paid for the actual injury and related medical costs. If it’s for something else consult a tax professional to make sure it is handled correctly.
If you have a settlement from before that has created a large tax debt, consult with one of our tax attorneys. Our tax law firm in Las Vegas handles client cases nationwide.