Are Personal Injury Settlements Taxable?

By John DiBartolo on March 15, 2024
Toy pink piggy bank on work table of recently injured senior tenant, homeowner woman.

After receiving a personal injury settlement, you’re probably relieved that you have the money needed to cover your medical bills, lost wages, and pain and suffering. But now you have another worry: If you get a settlement, do you pay taxes on it?

This is a critical question, and we have all the answers below. If you have follow-up questions about personal injury settlement taxation, The Law Offices of John P. DiBartolo, Jr. can answer them. He is highly experienced in all kinds of personal injury claims, including auto accidents, slips and falls, product liability, and more. Speak to one of our auto accident attorneys for a free personal injury consultation today at (413) 529-2955.

Personal Injury Settlement Overview

If you are injured because of another person’s wrongful or negligent acts, you can file a claim to obtain compensation for your losses. You may file a civil action in court, which will award you damages if you can prove liability. Or, you may negotiate a personal injury settlement. In most cases, such as after a car accident, you negotiate a settlement with the at-fault party’s insurance company.

The liable party’s insurance provider may offer a settlement in exchange for not pursuing a personal injury lawsuit. These funds are your personal injury settlement, which typically compensates you for medical bills, lost earnings, pain and suffering, and emotional distress from your injuries.

Personal injury settlements can be tens of thousands to millions of dollars. That is why it is so essential to understand if personal injury settlements are taxed.

Federal Taxation And Personal Injury Settlements

IRC Section 61 Overview

The rules regarding the taxability of personal injury settlements can be found in Internal Revenue Code (IRC) Section 21. The law states that all income is federally taxable from whatever source unless another area of the code exempts it. IRC Section 104 excludes taxable income for most lawsuits, settlements, and awards.

Thus, per IRC Section 21, the federal government does not generally tax a personal injury settlement. Most parts of your settlement, such as medical bills, lost earnings, and pain and suffering damages, are payment for the damages suffered from your injuries. Compensation for such damages helps you recover from injuries, get your life back on track, and make yourself whole again.

Therefore, the US government doesn’t consider most personal injury settlements to be income funds. It does not impose federal taxes on most of your personal injury settlement. They are considered compensatory damages, and the US government assumes you had a loss equal to the funds you received.

So, there is not any income to tax. This is the case whether you obtain funds in a lump sum, a monthly basis, or through another payment plan. For instance, if you settle your car accident claim for $20,000 for physical injuries, they are not taxable.

Federal Taxation Exceptions

There are always exceptions, and most involve compensation beyond paying for medical, financial, and emotional damages.

A critical exception with federal taxation of a personal injury settlement involves emotional distress damages. The origin of the distress is vital: Is the emotional distress related to a physical injury? For example, if you lost your leg in a car accident and have emotional distress related to the loss, that compensation would not be taxed by the federal government. However, emotional damages are usually taxable if the emotional distress stems from a non-physical injury.

If you developed PTSD after seeing a deadly car accident, the damages are for mental and emotional distress, not physical injuries. Thus, this compensation would likely be considered taxable income. Or, if a dog bit you, your settlement wouldn’t be taxable if it was for the bites on your leg. But a settlement for developing PTSD after a dog almost bit you would be taxable.

The next federal taxation exception deals with punitive damages. No matter the details of your claim, punitive damage awards are provided above and beyond any compensatory damages. So, punitive damages are considered income for federal taxation purposes. For example, if you received punitive damages in a drunk driving accident settlement, that portion of the settlement would be taxed at the federal level. The US government also taxes parts of wrongful death settlements, including punitive damages.

The last exception for federal taxation involves interest and deductions from the settlement. If the judge awards the plaintiff with a settlement with interest, federal taxes would apply to the interest part only. If you took a tax deduction last year for your medical bills, you cannot take the deduction in the current tax year; it must be reported on the current year’s taxes.

Massachusetts Tax Exemptions

The Commonwealth of Massachusetts taxes compensation for lost wages or lost profits.

Wrongful death settlements are generally not taxable by Massachusetts. However, Massachusetts will typically assess inheritance taxes if the wrongful death settlement is awarded to the decedent’s estate.

Detail cropped shot of suffering from pain unrecognizable young woman with broken hand wrapped in plaster bandage.

Allocating Personal Injury Damages To Reduce Tax Liability

Most legal disagreements after an accident involve several kinds of damages. The parties to the dispute should agree on the amount paid and how it is taxed. For instance, if you and your personal injury attorney agree to confidentiality as part of the settlement, establish an amount for agreeing to confidentiality, and then name the rest as compensation for any physical injuries. You could owe taxes on what you received for the confidentiality agreement, but there is no tax on what you receive for physical damages.

Agreements between the plaintiff and defendant regarding tax treatment are non-binding for the IRS and state tax agencies. But carefully allocating the settlement offers the best way to reduce your tax obligations. A structured settlement, for example, can be a useful tool to reduce tax obligations from a personal injury settlement.

An excellent example of why it is essential to allocate settlement damages carefully can be seen in the case involving former NBA star Dennis Rodman. In 1997, Rodman accidentally landed on a cameraman and then kicked him. The man went to the hospital, and Rodman compensated him $200,000 for the injury. However, there was an agreement that the settlement would be confidential.

The cameraman didn’t pay income taxes on the settlement, and the IRS came after him. In 2003, the US Tax Court stated that $120,000 of the $200,000 settlement was for physical injuries, and $80,000 was for the confidential agreement, meaning the $80,000 was taxable.

About Attorney John P. DiBartolo, Jr.

Personal injury settlements can provide extensive financial relief after an accident. But the last thing you want is to deal with more stress at tax time. If you aren’t sure if the federal or state government will tax part of your settlement, talk to one of our personal injury attorneys or your tax professional.

Attorney DiBartolo is a frequent lecturer for the Massachusetts Bar Association and the Massachusetts Academy of Trial Attorneys. He and his associate attorney have many impressive personal injury testimonials and can help with any personal injury claim, including car accidents, truck accidents, medical malpractice, premises liability, and more. Please call (413) 529-2955 for a complimentary legal consultation.

Category: Personal Injury