Generally speaking in a typical car accident settlement or slip and fall case the answer is no.
The IRS excludes from taxable income damages received on account of personal physical injuries, whether by suit or settlement.
Also excluded from taxable income are amounts received under workers compensation laws for injuries and sickness incurred as a result of employment. This includes lump sum settlements.
This is all spelled out in the Internal Revenue Code at section 104.
Exceptions: Where There Is Tax on Personal Injury Settlements
Nothing having to do with tax law can be that easy though can it? There are exceptions. What are they?
Emotional distress. Note above we said recovery for personal physical injuries are not taxable. Under the tax law emotional distress shall not be treated as physical injury or physical sickness. Where emotional distress recovery is awarded, the only amounts excluded from taxation are the actual out of pocket medical costs. If you are confused about any taxation laws and want some advice then you should visit this TaxPage to gain advice and help from a professional.
Punitive damages. These are damages that go beyond awards based simply on pain and suffering or the extent of an injured person’s disability. Punitive damages generally come in when the defendant acted recklessly, with malice, deceit or any other conduct justifying a court to penalize or make an example out of the wrongdoer. Punitive damages are taxable, with an exception under the laws of certain states allowing only punitive damages in wrongful death cases.
Employment related economic loss. Lawsuits involving wrongful discharge, breach of employment contracts and discrimination often seek damages to make up for economic losses such as lost wages, business income and various benefits. Such awards are in fact taxable unless a personal physical injury caused the loss.
Interest. Any portion of an award or settlement designated as interest is taxable.
Tax on Personal Injury Sample Case
Damages compensating the injured person “on account of personal injuries” are not taxable. The IRS offers an example of a $30,000 settlement to a taxpayer injured in an automobile accident. The car accident caused medical bills, lost wages and pain and suffering including emotional distress that’s hard to measure precisely.
As long as the injury victim has not previously deducted the medical expenses the entire $30,000 settlement is tax free. This is because the medical expenses were incurred “on account of personal injuries”. So, too were the lost wages and pain and suffering “on account of personal injuries”. In this case all damages are excluded from taxable income.
Problems rear their ugly heads in the intricacies of tax law. After any settlement always consult with the CPA or other professional who does your taxes. Getting it right the first time can save massive headaches and money in the long run.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.