People settling personal injury claims must understand the tax implications involved, since tax liability can erode the true value of such settlements. Attorneys representing injured people may be able to provide some tax advice to their clients. However, unrepresented accident victims may not know about the various tax rules and regulations governing settlements from personal injury claims.
Title 26 of the United States Code, Section 104, lists types of compensation that are not treated as taxable income. Specifically excluded from federal income tax are any amounts obtained under a state's workers' compensation act or civil law for personal injury or sickness. However, the statute specifically authorizes taxation on punitive damage awards or settlements, even when stemming from a personal injury. Lump-sum settlements and structured settlements are treated identically.
The language of Section 104 does not specify which types of recovered money stemming from a physical injury claim is nontaxable. Experts in the field generally agree that settlements and awards for lost income, medical bills, and physical pain and suffering are nontaxable if they come from a physical injury claim. The Internal Revenue Service specified in a 2009 bulletin that amounts received for mental pain and suffering stemming from a physical injury will be nontaxable. Also, the IRS has ruled that personal injury awards awarded under "no-fault" statutes and traditional tort laws will not be treated as taxable income.
Taxable Awards and Settlements
Damages for claims other than physical injury are typically treated as taxable income. Up until 1996, the IRS excluded virtually all damage settlements and awards from taxable income. Even claims like defamation and invasion and privacy were nontaxable income. That year, Section 104 of the tax code was changed to its current form. Because of the somewhat nebulous language, litigants continue to question which conditions count as "physical injury" or "physical sickness." Courts have determined that headaches, insomnia and stomachaches are not significant enough to qualify.
Litigants can consider language to be included in settlement agreements and the tax implications. For example, a plaintiff pursuing both taxable and nontaxable causes of action against a defendant could potentially agree to dismiss her taxable claims and settle only the nontaxable claims. Such maneuvering could save money for both parties by preventing tax liability and allowing the entire case to settle for a lower amount. All parties would want to specify in writing that the settlement included only the nontaxable claims.
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