Jan 19, 2019

Personal Injury Settlements and Taxes

Legal Settlement - Blank Check Disbursement
A lawsuit settlement check with the words Your Name Here, indicating that you could be eligible for a big payout on a legal suit

Most of us know that personal injuries are unplanned events. Most people would rather avoid injuries.  But when an incident does happen, victims may recover compensation to get their life back on track. A personal injury settlement helps avoid court. Most of all, it compensates them.

The agreement will cover them for medical expenses, lost wages, pain and suffering, and other damages. So this is a financial award to help in the healing process after an accident due to carelessness or recklessness. But "hush-hush" confidentiality arrangements are becoming more and more popular.

Publicly reported settlements remain common. And some people don't want that for various reasons. (a minor involved, a large company doesn't want more claims from copycats, etc.) But if you're not careful, this type of contract can impact your personal income taxes.

Compensation—Loss and Non-Taxable Money

Normally, compensation for medical expenses or pain and suffering has no impact on owed federal income taxes. Compensating the person who suffered physical harm losses remains the object. That's why normally this isn't taxable money.  Why? Because federally, it's not earned income.

What about Lost Wages?

Compensation is awarded that may be considered taxable money when the claimant is awarded money for lost wages. So this would be regarded as income that would usually appear on the claimant's W-2 federal tax form. The IRS would receive a copy of from the employer. Applicants who live in states where there are state income taxes are responsible for the taxes on the awarded compensation. And typically, it would be reported by the employer when it is for lost wages.

State Law and Personal Injury Settlements

In some states, the law will contradict federal law when it involves financial compensation or a personal injury. Major portions of injuries claims are not subject to federal taxes. But certain states require individuals to pay taxes on all of their award. And this includes a financial settlement.

Knowing that these laws can vary from one state to another, it is essential for taxpayers to see the tax laws of the state in which he or she is domiciled in or resides. Consulting with a tax attorney, or a CPA is the best way to learn. So do so before filing state or federal income tax returns or even settling for that matter.

Do Confidential Settlements have Tax Implications?

Many PI lawyers may not be aware of this. If you do a confidential PI settlement, the IRS will come after both parties for taxes. But tax avoidance remains possible with a proper settlement contract.

You heard right. Remaining quiet. The exchange is for confidentiality. Examples could include cases where a child gets raped on a cruise ship. Both the parents and the cruise industry wants to keep this delicate matter "hush-hush."

Since this additional side deal for confidentiality has nothing to do with the actual injury, it is subject to tax consequences.  The IRS will assess a reasonable amount for the "silence." So spelling out the cost of silence purchased makes sense.  Sometimes the tax assessment is so outrageous; no compensatory award remains for the injured party. To help alleviate this risk, the parties need to spell out the amount. Also, it must show who is bearing the burden of the tax consequences. Otherwise, do not engage in a confidential settlement at all!

What About Settlements more than Loss?

There are some compensation awards which generally will occur in a civil court setting. And these may be over the actual losses of the victim. Punitive damages raise the issue of tax liability. The extraordinary portion of the verdict or settlement remains taxable.

Under the federal tax laws, this financial gain over what the actual losses suffered are is taxable income. When a judge approves this type of award, the court records will show the amount of taxable compensation. Other income is typically how your accountant classifies the amounts when filing your return.

Other Resources:

"Confidentiality in Settlement Agreements Is Bad for Clients, Bad for Lawyers, Bad for Justice" (ABA): https://www.americanbar.org/publications/gp_solo/2012/november_december2012privacyandconfidentiality/confidentiality_settlement_agreements_is_bad_clients_lawyers_justice.html

"IRS Issues New Rules For Tax-Free Legal Settlements" (Forbes): https://www.forbes.com/sites/robertwood/2012/01/31/irs-issues-new-rules-for-tax-free-legal-settlements/