One of the first things that most people want to know when they receive an award after an auto accident settlement is whether they have to pay taxes on this money. The answer may depend on how the verdict or settlement is structured and the circumstances of the award.
Only a tax advisor can ultimately answer questions about taxes. However, it helps to have an understanding of the basic ground rules of how settlements or verdicts in personal injury cases may be subject to being taxed.
Internal Revenue Service Code and Taxable Damages
Every tax authority may have its own rules about what can be taxed, but the IRS or the federal taxation authority is the one with whom most people are concerned. According to the Code of Federal Regulations, damages received for personal physical injuries or sickness are not taxable. However, money received for emotional damages or punitive damages may not be considered part of the physical injury or sickness settlement and may be taxable unless the emotional damage is directly related to the physical distress. For more information on the different types of damages, read our article “Understanding Personal Injury Damages“.
Here are a few general rules about different types of reimbursements and how they can be taxed:
- Most amounts that are considered compensatory damages, or damages that compensate you for direct expenses such as medical bills, are typically not taxable. However, if you have already taken a deduction for your out-of-pocket medical expenses on a tax return when you receive the award, that portion may be subject to tax.
- Money received for car repairs, rental expenses while your car is in the shop or other property damage is usually not taxable.
- Money you are awarded for lost wages is generally subject to income tax. This is because the compensation you would have received in the normal course of business would have been taxed, so any amount you receive as restitution for income should also be taxed.
- Emotional damages may be taxed, but pain and suffering is usually not. Therefore, it is important to determine how the settlement or award is structured to determine whether these amounts are taxable.
- Punitive damages are relatively rare. They are usually awarded when someone has committed a deliberately negligent or egregious action and the court wants to punish the offender. These types of damages are usually taxable when they are awarded because they are not considered compensatory.
State Laws vs. Federal Laws
While the IRS rules and regulations apply to everyone, state codes can vary widely. Each state implements its own tax rates and regulations and interprets insurance policies differently. Therefore, it is important to talk to a tax expert who can explain state laws and provide guidance for managing the taxes on a personal injury settlement.
A personal injury attorney is not usually a tax expert. However, a personal injury attorney can work with a tax expert to help you understand your settlement and deal with the tax consequences.