Personal Injury Settlements and Taxes
Most of us know that personal injuries are unplanned events. And usually, people would rather avoid being personally injured. But when an incident does happen, the victim is often entitled to recover compensation to get their life back on track. When an individual obtains a personal injury settlement, it compensates them.
The agreement will cover them for medical expenses, lost wages, pain and suffering and other damages. So this is a financial award to help in the healing process after an accident due to carelessness or recklessness. But this financial gain that is used to offset the costs related to an accident may also have an impact on personal income taxes.
Compensation—Loss and Non-Taxable Money
There will be no impact on federal income taxes due when a person is awarded compensation for medical expenses or pain and suffering. The reason that this is not taxable money is that it is to compensate the person who suffered harm losses. This financial gain is not considered as earned income under federal tax laws.
What about Lost Wages?
Compensation is awarded that may be considered taxable money when the claimant is awarded money for lost wages. So this would be considered income that would usually appear on the claimant’s W-2 federal tax form that the IRS would receive a copy of from the employer. Applicants who live in states where there are state income taxes will also be responsible for the taxes on the awarded compensation. And typically, it would be reported by the employer when it is for lost wages.
State Law and Personal Injury Settlements
In some states, the law will contradict federal law when it involves financial compensation or a personal injury. In these states, an individual may not be required to pay federal taxes on a significant portion of the personal injury settlement. In other states, the law includes terminology that requires the individual to pay on all of their earnings. And this will typically include a financial settlement.
Knowing that these laws can vary from one state to another, it is important for taxpayers to know the tax laws of the state in which he or she is domiciled in or resides. This can be done through research, consulting with a tax attorney, or a CPA. So do so before filing state or federal income tax returns.
Do Confidential Settlements have Tax Implications?
Many PI lawyers may not be aware of this. The sad truth is that the IRS will come after someone for taxes in a confidential PI settlement unless the agreement is structured correctly. You heard right. In these cases, confidentiality is being purchased to keep a party quiet. Examples could include cases where a child gets raped on a cruise ship, and both the parents and the cruise industry wants to keep this delicate matter “hush hush.”
Since this additional side deal for confidentiality has nothing to do with the actual injury, it is subject to tax consequences. If it is not spelled out how much the silence was purchased for, the IRS will assess an amount. Sometimes the tax assessment is so outrageous; no compensatory award remains for the injured party. To help alleviate this risk, the parties need to spell out the amount. Also, it must show who is bearing the burden of the tax consequences. Otherwise, do not engage in a confidential settlement at all!
What About Settlements more than Loss?
There are some compensation awards which generally will occur in a civil court setting. And these may be over the actual losses of the victim. This usually happens in personal injury cases where punitive damages are awarded. Under the federal tax laws, this financial gain over what the actual losses suffered are is taxable income. When a judge approves this type of award, the court records will show the amount of taxable compensation. This money can be reported as other income when filing a federal income tax return.
“Confidentiality in Settlement Agreements Is Bad for Clients, Bad for Lawyers, Bad for Justice” (ABA): http://www.americanbar.org/publications/gp_solo/2012/november_december2012privacyandconfidentiality/confidentiality_settlement_agreements_is_bad_clients_lawyers_justice.html
“IRS Issues New Rules For Tax-Free Legal Settlements” (Forbes): http://www.forbes.com/sites/robertwood/2012/01/31/irs-issues-new-rules-for-tax-free-legal-settlements/