Tax Time: Is Your Settlement Taxable?

Happy Tax Week everybody! Here's some useful information on everyone's favorite subject!

Happy Tax Week everybody! Here's some useful information on everyone's favorite subject!

This article contemplates taxes, which is always a highly complicated subject.  While I'm happy to give whatever insight I have, I cannot recommend highly enough that you go and speak with a tax expert on these matters.

Ah man, I thought I was done with taxes for awhile!

It's that time of year! Hopefully, you've got your taxes filed and you're getting a sweet refund. Not to brag, but I netted about twenty bucks this year.  Stacks on stacks, right?

One question that I get asked on a regular basis is whether personal injury settlements (or judgments) are taxable.  The short answer is that some of it probably is and some of it probably isn't; the analysis tends to revolve around what the settlement is designed to compensate.  

Let's jump into the details.

In most cases, a personal injury settlement is a lump sum of money designed to compensate the claimant for a variety of different damages.  These can include property damage to your vehicle, lost income, medical bills and expenses, pain and suffering, future medical treatment, out-of-pocket expenses, lost earning capacity, and a host of others.  

So keep in mind that, for the most part, the taxes that you pay are taxes on your income.  It stands to reason, therefore, that only the aspects of your personal injury settlement pertaining to said income would be subject to taxation.  Since most personal injury settlements and judgments primarily address non-income damages, the general rule is that your personal injury settlement or judgment will not be subject to taxation at either the federal or state level.  This even goes so far as to apply to income that you're no longer able to earn because of a permanent injury or impairment.

Nice! Any exceptions?

Of course there are!  The most common exception is for lost wages; since this is income that you missed out on, it will still be considered income even if it's gained through a personal injury settlement.  The second most common exception that I see is where a claimant has claimed a deduction on medical expenses in past years.  If you claimed your medical expenses as a deduction in 2015, then got a settlement in 2016, you'll generally need to claim that money as income in 2016.

Another exception is for interest on a judgment.  What this means is that when you get a judgment in court, you'll often also get interest on that verdict, running from the time that your lawsuit was filed.  So let's say that you filed your lawsuit on June 30, 2014, and obtained a judgment of $20,000 on January 1, 2016.  The defendant appealed, and the Court of Appeals denied the appeal (or, in other words, affirmed the decision of the trial court) on June 30, 2016.  In this situation, you'd be entitled to your judgment plus two years' worth of interest thereon.  The judgment itself would not be taxable, but the interest on it would be.

The other big exception is punitive damages.  This means that in a situation where particularly egregious behavior has occurred, like where the insurance carrier has engaged in bad faith, you could be entitled to extra damages above and beyond the amount of your actual losses.  So if you file a claim and the carrier refuses to investigate it, you could have a claim for bad faith.  Let's say you file your lawsuit and successfully plead insurance bad faith and Unfair and Deceptive Trade Practices, and the trial court awards you your actual damages of $20,000, trebled pursuant to N.C. Gen. Stat. § 75-1.16, for a total judgment of $60,000.  Your actual damages ($20,000) are not taxable in this scenario, but your punitive damages ($40,000) are.  My practice in this situation is always to ask the judge to split up the award into compensatory damages and punitive damages.  This allows the IRS to clearly see the portion of the award that isn't subject to taxation.

That's about it.  If you have questions, please call the office and we'll chat.  If you have tax questions, I strongly recommend, again, that you get in touch with a tax expert.  This stuff is complicated, and it's nothing to take lightly.  Good luck!