In general, personal injury settlement and verdict proceeds are not subject to state or federal taxes. However, there are three possible exceptions: (1) awards punitive damages, (2) damages for emotional distress, and (3) damages for lost wages. Depending on the case, these three types of damages can be taxable.
1. What is the general rule on the taxability of injury settlement offers?
Federal and state laws generally say that the money received in a personal injury claim is not taxable.1
This rule applies no matter if you:
- settle a personal injury case, or
- win a verdict at a trial for a personal injury lawsuit.
In practice, the rule means that you do not have to include such damages as medical bills and pain and suffering in your gross income.2
2. What about a settlement for a case involving a physical sickness?
Under the Internal Revenue Code, a taxpayer can exclude from gross income the amount of any compensatory damages received on account of personal injuries or physical illness/sickness.3
Example: Joe works at a manufacturing plant. His employer negligently exposed him to a germ. As a result, Joe suffers a bad physical sickness, and later files a workers’ compensation claim with his employer’s insurance company.
If Joe successfully settles the claim, he does not have to include any of the proceeds in his gross income. The money is not taxable.
3. Are punitive damages taxable?
Punitive damages represent one main exception to the general rule involving the taxability of awards involving personal physical injuries.
This exception says that punitive damages in a settlement agreement are always taxable.4
Note that punitive damages are different from compensatory damages. The latter is designed to compensate an injury victim for certain losses (like medical expenses, lost income, and emotional distress).
In contrast, punitive damages are awarded in order to punish a defendant in a personal injury case for intentional or highly reckless behavior.5
Note that if you receive punitive damages in a case, your personal injury attorney will usually make a request to the judge or jury. The request asks to clearly indicate in the verdict (or on a portion of your settlement) the exact amount of compensatory damages and punitive damages.
This request ensures that you can prove on a tax return those proceeds which are tax-free.
4. What about the taxability of emotional injury awards?
If a settlement award or verdict is given for purely emotional distress or mental anguish, then the money is taxable.
Recall that the part of your settlement that includes proceeds from a personal injury or physical illness is not taxable.
Emotional distress is not considered a type of personal injury or physical injury for tax purposes.
Therefore, any money from an emotional injury award must be included in your gross income.
Note that if you have a case involving emotional distress, you should seek legal advice from a personal injury lawyer or law firm.
An attorney will usually help try and show that your emotional injury case involves other types of damages, like damages from a physical injury. If successful, then you would not have to pay taxes on a final settlement.
5. Are awards for lost wages taxed?
With regards to lost wages, in theory, these are not taxable if recovered in a personal injury case. However, courts have often held that compensation for lost wages is taxable. The reasoning is that your lost income would have been taxable if earned, so it should be taxable when recovered in a lawsuit.6
But in practice, many personal injury settlements often come in a lump sum with no clear distinction regarding how much money is allocated for different types of damages. This can make it difficult to determine if and how lost wages should be taxed.
Legal References:
- Internal Revenue Code Section 104.
- IRS Rev. Rul. 85-97. See also Commissioner v. Schleier, 515 U.S. 323 (1995).
- Internal Revenue Code 104a2.
- See same. Note, though, that in some wrongful death claims, punitive damages may be excluded from your income tax.
- See, for example, California Civil Code Section 3294. See also Florida Statutes 768.72.
- See for example, C.I.R. v. Schleier (1995) 515 U.S. 323.
