Leucadia Law & Mediation

Is Your Settlement, Verdict, or Award Taxable?

A prospective client informed me that his Certified Public Accountant (CPA) indicated to him that the part or all of the proceeds of his personal injury action, in which he and his son were severely injured in a car vs. motorcycle accident, may be taxable.  I was aghast.  As far as I knew, personal injury settlements, verdicts, or awards were non-taxable and employment-related settlements, verdicts, or awards were potentially taxable as income.

Fortunately, my simple understanding was more or less accurate, albeit oversimplified and incomplete.  The IRS looks at whether the settlement, verdict, or award is intended to make you whole (non-taxable) or whether it is income (taxable).  The definition of “income” is an accession to wealth, clearly realized, over which you have dominion.  Since that means nothing, we have to dig a little deeper and get into specifics to determine what is and is not taxable.  The IRS uses the term “excludable from gross income” to mean non-taxable.  Why can’t they keep it simple?  It’s the IRS.  If it was simple then we’d all understand, and the IRS couldn’t sleep well at night if we were to collectively understand the tax code.

Here’s what the IRS says about physical injuries[1]:

If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. [These] damages…are excludable from gross income [i.e., non-taxable].  [T]he exclusion from gross income under IRC section 104(a)(2) also applies to any compensatory damages received based on a claim of emotional distress or mental/emotional injury that is attributable to a physical injury or physical sickness.

In an employment context, damages received to compensate for economic loss, for example, lost wages, business income, and benefits, are taxable unless a personal injury caused the loss.  Back pay received on a claim for denial of a promotion due to disparate treatment or discrimination is taxable.

Any other non-physical injury is taxable, whether the claim is for emotional distress (without a physical injury underlying it), breach of contract, fraud, or negligence. Because these are nonphysical injuries, under the current version of IRC section 104(a)(2), only out-of-pocket amounts for medical costs incurred to treat any emotional distress claims would be excludable from income.  All amounts determined to represent punitive damages are taxable under IRC section 104(a)(2).

Finally, any interest associated with a settlement, verdict, or award is always taxable.

The bottom line is that you will definitely want to consult a lawyer when constructing your settlement agreement, and you may be wise to consult your CPA as well.