Are Negligence Settlements Taxable?

Negligence lawsuits can include claims for damaged property, personal injury, emotional trauma, loss of income, and a host of other reasons. When cases are settled, the parties and the attorneys involved will typically consider the tax ramifications for everyone involved. Generally, only settlements for physical injury claims are nontaxable. The IRS treats other types of negligence settlements as taxable income.

Settlements

Negligence settlements result in money damages being paid to the injured party. The injured person can settle his claim with or without an attorney. A negligent business or individual, or an insurer, may make the payment. Some claims are settled without a lawsuit while other claims are settled after years of litigation, sometimes on the morning of trial. Settlements can range from small claims courts matters to significant settlements for wrongful death, lost limbs, head injuries and paralysis.

Physical Injury

Federal law only treats settlements for physical injury as nontaxable. The statute uses the words "personal physical injuries" and "physical sickness." Therefore, a claimant suffering such an injury will not have to pay taxes on the settlement. However, disagreement remains about what actually constitutes "personal physical injuries" or "physical sickness." The IRS generally argues that an observable injury like a bruise or broken bone is necessary.

Taxable Settlements

Many other types of negligence settlements will be treated as taxable income for the recipient. For example, claims of negligent infliction of emotional distress will be fully taxable because there is no physical injury or sickness. Claims for property damage caused by the negligent acts of others will also be fully taxable. Before resolving these cases, plaintiffs should determine the likely amount of taxes owed and decide whether to settle or pursue the entire amount owed to them at trial.

Effect on Settlement

Thoughtful attorneys and parties can use tax considerations to increase the chances of getting a case settled. For example, an injured party may have a claim for physical injury and emotional distress against a negligent driver. The driver's attorney may suggest that the plaintiff dismiss the emotional distress claim, leaving only the nontaxable physical injury claim. The defendant can end up paying less and the plaintiff can end up accepting more by cutting out the IRS entirely. The parties can specify in the settlement documents that the settlement was for physical injury only.

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About the Author

E.S. Martin is an attorney who has worked in civil litigation for more than eight years. He focuses his work in insurance, personal injury, subrogation and risk management.

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