Settlement money escapes the taxman if it results from a personal injury. Any other settlement, like an award stemming from an employment discrimination allegation, will be taxed. That’s the simple answer. However, there are rules in the tax code that could cause a personal injury settlement to be taxed, at least in part.
There are two thresholds you must meet in order to consider your settlement tax-free. The settlement must be the result of a personal injury, which could include an illness, and the wrongful party must be the reason for the settlement. If damages were awarded because of an act of negligence, you are in the clear in terms of taxes. If it was determined there was no wrongdoing involved, the settlement is taxable.
The reason for the non-tax status stems from laws created in 1918. Legislation determined compensation for physical injury was not income and, therefore, under the 16th Amendment was not considered a gain. According to the tax code, the money awarded in a settlement is meant to make the victim whole again. Settlement money can go to pay for items including lost wages, medical bills, pain, suffering, emotional stress, attorney fees and other related harms or losses.
In the case of a car accident, certain items are considered taxable and others are not. If the settlement was used to bring you back up to original condition before the accident, the settlement is not taxable. For instance, the funds were used to repair the vehicle and cover medical costs associated with injuries sustained in the accident. In essence, no value was added since the funds were used to return you to normal.
Punitive and Compensatory Damages
If your settlement includes punitive or compensatory damages, or both, then expect to pay taxes. Punitive damages, which are awarded to punish the wrongdoer, are in addition to actual damages. Compensatory damages are awarded to make up for time lost from work. Both of these add value, or income, to the victim and are thus taxable.
A structured settlement is considered tax-free. The Periodic Payment Settlement Act of 1983 made these payment arrangements tax-free as a way to promote the concept of a structured settlement, according to the National Structured Settlements Trade Association. In this situation an award is delivered over time, sometimes over the life of a victim; instead of receiving $200,000 all at once, payments are made over a period of years. The reason it is tax-free has to do with ownership of the money. In a structured settlement, known as an annuity, the money does not go to the victim. A defendant pays the insurance company who in turn sells the annuity to what is called an assignment company. They arrange delivery of payments to the victim and they are the owners of the money. A 1997 law encouraged more structured settlements, this time allowing for workers’ compensation benefits to be delivered periodically over time.
Compensation from an emotional injury was considered tax-free. However, that changed in 1996 after the Small Business Job Protection Act was adopted. Settlements resulting from defamation or invasion of privacy were also made taxable in 1996. This Act limits non-taxable settlements to only those resulting from physical injury or physical sickness. However, a specific definition of what constitutes a physical injury does not exist. According to Robert W. Wood, a contributor to Forbes Magazine, most IRS appeals cases revolve around the question, “Is there bodily harm?”
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