- Medical expenses. The portion of a settlement that can be attributed to medical expenses related to the injury is not taxable unless expenses were included as an itemized deduction on a prior year’s tax return. If a deduction was taken that portion of the settlement may be taxable. Essentially, once a deduction is claimed a taxpayer can’t double up on recovery by also receiving a settlement payment for the deducted amount. For settlements covering multiple years of care, the taxpayer will need to follow a process to allocate the settlement across each year of expenses and make a report of income accordingly.
- Emotional distress and mental anguish. As with medical expenses, noneconomic damages for emotional stress or mental anguish are not ordinarily taxable provided they originated from a physical injury or illness. This proviso is can create interesting questions if psychological harms covered by the settlement aren’t related to an injury itself but might be traced to another cause. Note, however, that such awards are subject to adjustments for related medical expenses (i.e., such expenses may still be deducted as usual).
- Lost wages and lost profits. A settlement that includes a payment for lost wages or lost profits will be taxable in the same way as though those amounts were earned in the ordinary course of work. Lost wages are also subject to employment (social security and Medicare) taxes.
- Interest. Many settlements are structured in such a way that the defendant pays a certain regular sum over a period of time. In a structured settlement the defendant often pays a certain interest rate on top of the principal. In such cases, the interest component of the payments is taxable income.
- Property damage. If a settlement also includes compensation for property damage, it will be taxable only if the payments are greater than the taxpayer’s basis in the property. Basis is a tax term that in simple terms means the value that the taxpayer originally paid for the property, plus any costs paid into it. For example, a person who buys a valuable work of art for $5,000 has that amount of basis in the piece. If the art has appreciated to be worth $50,000 when it is destroyed, receiving compensation for the full value may trigger income tax for the $45,000 difference.
The goal of a personal injury lawsuit is not to make the injured person rich. Rather, it is to ensure that the injured person doesn’t have to bear the cost of injuries caused by someone else’s negligence or misdeeds. Most lawsuits settle out of court, often with the result that the defendant enters into an agreement to make one or more payments. The payments may be made directly to health care providers who are owed for services already rendered, or they may go directly to the plaintiff to help offset the cost of future care or other damages. A key question is the extent to which settlement payments are taxable for federal tax purposes. Predictably, the answer to the question of whether settlement payments are taxable income is: it depends. Specifically, the answer depends on the nature of the payments (i.e., what they are compensating the plaintiff for) and, sometimes, how the expenses they are covering were reported on prior tax returns. The IRS provides some insights in Publication 4345 with respect to certain specific types of compensation: