Injured man filing in Personal Injury Claim Form

Will I Be Taxed on My Personal Injury Settlement?

Tormey & McConnell Dec. 22, 2023

When we talk about personal injury settlements, one of the first questions that often comes up is, "Will my settlement be taxed?" It's an important question, and understanding the answer can have a significant impact on your financial outcome. The tax code can be a complex beast, full of rules and exceptions, so it's always wise to consult with us and a tax professional to ensure you're complying with the law. 

Personal injury settlements can be tricky, and understanding the potential tax implications is a crucial part of the process. At Tormey & McConnell, we're here to help clear the fog. 

The Non-Taxable

According to the IRS, compensation received for physical injuries or physical sickness is generally not taxable. This applies whether the money comes from a settlement or from winning a case at trial. It's not just about physical injuries either. If you've suffered emotional distress related to those physical injuries or sickness, that compensation is also generally non-taxable. 

And it doesn't stop there. Did you lose income because of your physical injuries or sickness? Any compensation you receive to cover that lost income is typically non-taxable too. We know how important it is for you to recover financially after an injury, and these tax rules are designed to help you do just that. 

The Taxable

Now, let's talk about the parts of your settlement that might be taxable. If you receive compensation for emotional distress that isn't related to physical injury or sickness, that's generally going to be taxable. It's a subtle distinction, but an important one. 

Punitive damages are another area where taxes come into play. These are awarded not to compensate you for your injury, but rather to punish the wrongdoer. Because they're not tied to a physical injury or sickness, punitive damages are generally taxable. 

And finally, there's interest. If you receive interest on your personal injury settlement, that's typically taxable. It's like earning interest on a bank account or investment — the IRS will want a piece of it. 

The Strategy of Allocating Damages

One strategy we can use to potentially limit your tax liability is the allocation of damages. By agreeing with the other party on how much of the settlement is allocated to different types of damages, we can potentially reduce the taxable portion. For example, if you're agreeing to a confidentiality agreement as part of your settlement, we can allocate a specific amount to that agreement, which may be taxable, while allocating the rest to compensation for your physical injuries, which would generally be non-taxable. 

It's worth noting that agreements about tax treatment are not binding on the IRS or the courts. However, allocating your settlement can give you the best chance of minimizing your tax liability. A famous case involving Dennis Rodman illustrates the importance of allocating damages. In that case, the Tax Court ruled that a portion of the settlement was for physical injuries (non-taxable) and another portion was for confidentiality (taxable). 

State Taxes: A Word of Caution

While we've been focusing on federal taxes, don't forget about state taxes. Most states follow the federal government's lead and don't tax personal injury settlements and judgments. However, tax laws can vary from state to state, so it's always a good idea to check with a local tax professional or us to understand the specific rules in your state. 

In our home base of Texas, state taxes generally don't apply to personal injury settlements and judgments. That's right — we follow the federal government's lead on this one. 

We're based in Amarillo, Texas, and serve clients throughout Canyon, Dumas, Pampa, Hereford, Childress, and Borger. Contact us today to schedule a time to discuss your case during a free consultation.  

Understanding the True Value of Your Settlement

When considering a personal injury settlement, it's important to understand the true value of the settlement offer. In addition to deducting expenses like attorney's fees and investigation costs, you also need to consider the potential tax implications. The IRS advises asking the question: "What was the settlement intended to replace?" This helps determine the tax treatment of the settlement. 

Understanding the tax consequences of a personal injury settlement can help you make informed decisions and avoid any surprises when it comes to tax time. Consulting with us and a tax professional is highly recommended to ensure compliance with the tax code and maximize your financial outcome. 

At Tormey & McConnell, we're here to guide you through the complexities of the tax code and help you navigate your personal injury settlement. We're not just your personal injury attorneys; we're your partners in your journey for justice, committed to securing your best possible outcome. Let's work together to turn the tables in your favor.