Is a Personal Injury Settlement Taxable?

If you were injured and are pursuing a personal injury case against the liable party, you may be wondering if you’ll be taxed on what you end up recovering on your case. The answer is, it will depend.

Is a Personal Injury Settlement Taxable?

Under federal law, personal injury settlements are generally not taxable if they are received on account of personal physical injuries or physical sickness.

According to 26 USCS § 104, amounts received as damages (other than punitive damages) on account of personal physical injuries or physical sickness are excluded from gross income. This exclusion applies whether the damages are received by suit or agreement (settlement) and whether they are paid as lump sums or periodic payments.

However, it is important to note that this exclusion does not apply to punitive damages, which are taxable. Courts award punitive damages in addition to compensatory damages (e.g., past medical expenses, pain & suffering, etc.) to punish the defendant for their wrongful conduct and to deter both the defendant and others from engaging in similar behavior in the future.

What If the Settlement Includes Lost Wages?

The IRS “has consistently held that compensatory damages, including lost wages, received on account of a personal physical injury are excludable from gross income.” Rev. Rul. 85-97 and also see Commissioner v. Schleier, 515 U.S. 323, 329-30 (1995).

What if the Settlement Agreement is Not Clear?

It is important to note that the taxability of a settlement can depend on the specific terms and the nature of the claims settled. For instance, if a settlement agreement does not explicitly allocate the settlement amount to personal physical injuries or sickness, the IRS will presume the entire amount is taxable unless the taxpayer can provide evidence to the contrary. Pipitone v. United States, 180 F.3d 859, Forste v. Comm’r, T.C. Memo 2003-103.

Also, if the damages are not on account of (attributed to) personal physical injuries or sickness, they are taxable. For example, emotional distress damages not attributable to a physical injury are taxable.

Is Interest Earned on Settlement Funds Taxable?

Yes, any interest earned on the settlement amount, such as from investing a lump-sum payment, is taxable. CGU Life Ins. Co. of Am. v. Metropolitan Mortg. & Secs. Co., 131 F. Supp. 2d 670, In re Greenly, 481 B.R. 299.

Therefore, while personal injury settlements for physical injuries or sickness are generally not taxable, it is crucial to examine the specific components of the settlement to determine the tax implications accurately.

Always Consult with a CPA or Tax Attorney!

We always recommend that you speak with a CPA or tax attorney to be 100% certain whether your settlement is taxable.