Is a Settlement Considered Income?

Is a Settlement Considered Income?

When you receive a settlement from a personal injury case, one of the first questions that may come to mind is whether you need to report this money as income on your tax returns. As any Waukegan personal injury lawyer will tell you, the answer isn't always clear, as it depends on several factors, including the nature of the settlement and your state's specific laws.

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Understanding Settlements

In legal terms, a settlement is an agreement between two parties to resolve a dispute without trial. In personal injury cases, settlements often involve a sum of money paid by the defendant (or their insurance company) to the plaintiff in exchange for dropping the lawsuit.

Settlements can cover various types of damages, including:

• Medical expenses
• Lost income
• Property damage
• Pain and suffering
• Emotional distress
• Punitive damages

The tax treatment of your settlement can vary depending on which of these categories your compensation falls under.

Federal Tax Laws and Settlements

At the federal level, the Internal Revenue Service (IRS) actively enforces specific guidelines on handling settlements for tax purposes. The general rule is that settlement money is taxable as income unless it falls under certain exceptions.

Physical Injury or Sickness

One of the most significant exceptions is settlements for physical injuries or sickness. According to Section 104(a)(2) of the Internal Revenue Code, compensation for physical injuries or bodily sickness is not taxable. This means that if you receive a settlement for medical expenses related to a physical injury, this portion of your settlement is generally not considered income for tax purposes.

However, it's important to note that this exception only applies to physical injuries or sickness. Settlements for emotional distress or mental anguish are generally taxable unless they are directly related to a physical injury or sickness.

Lost Income

If part of your settlement intends to compensate you for lost income, this portion usually incurs taxes. The reasoning is that if you had earned this income through regular employment, you may have been subject to income tax. Therefore, the IRS treats this part of your settlement as a replacement for taxable income.

Property Damage

Compensation for property damage is generally not taxable if the payment doesn't exceed the adjusted basis of your property. However, the excess may be taxable as a capital gain if the payment exceeds your adjusted basis.

Punitive Damages

Punitive damages, intended to punish the defendant rather than compensate the plaintiff, are almost always taxable. This holds even when courts award punitive damages in physical injury or sickness cases.

Interest

If your settlement includes interest (this can occur if there's a delay between filing the claim and receiving the settlement), this interest is generally taxable as "interest income" on your federal tax return.

State Tax Laws and Settlements

While federal tax laws apply uniformly across the United States, state tax laws vary significantly. Some states follow federal guidelines closely, while others have rules for taxing settlements. Additionally, some states don't have an income tax, which can significantly impact how your settlement proceeds.

States Without Income Tax

As of 2024, nine states do not levy a state income tax:

• Alaska
• Florida
• Nevada
• New Hampshire (only on dividend and interest income)
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

Regardless of its classification, you won't have to pay state income tax on your settlement in these states. However, it's important to remember that you may still owe federal taxes on portions of your settlement.

Reporting Settlement Income

If portions of your settlement are taxable income, you must report this on your tax returns. How you report this income can depend on the nature of the damages.

For example, if part of your settlement is for lost income, you will typically report this as "other income" on line 8 of Form 1040. Report interest income on line 2b of Form 1040.

It's important to keep detailed records of your settlement, including any documents that break down the settlement into its components (e.g., medical expenses, lost income, etc.). This documentation can be valuable if the IRS or your state tax authority ever audits you.

The Role of a Personal Injury Attorney

The tax implications of a settlement can be challenging, which is why many people choose to work with a personal injury attorney. A personal injury attorney can explain the potential tax consequences of your settlement and structure it to minimize your tax liability.

For example, a personal injury lawyer might negotiate with the defendant to allocate more of the settlement to non-taxable damages (like compensation for physical injuries) and less to taxable damages (like lost income or punitive damages). While the overall settlement amount might be the same, this can result in significant tax savings for you.

Additionally, a personal injury lawyer can ensure that your settlement agreement specifies the nature of the compensated damages. This clarity can be invaluable when it comes time to report your settlement on your tax returns.

It's important to note, however, that while a personal injury lawyer can provide general guidance on the tax implications of your settlement, they are not tax professionals. It's always best to consult a certified public accountant (CPA) or tax attorney for specific tax advice.

Structured Settlements

In some cases, particularly those involving large sums of money, you might be offered a structured settlement. Instead of receiving a lump sum payment, a structured settlement provides payments over time, often through an annuity.

Structured settlements can have different tax implications compared to lump sum settlements. Generally, the full amount of a structured settlement for physical injury or physical sickness is tax-free at the federal level, including the interest or earnings on the annuity. This can be a significant advantage over a lump sum settlement, where any interest earned on the settlement amount after you receive it will typically be taxable.

However, structured settlements also come with their considerations. Once established, they typically cannot be changed, which means you lose some flexibility in using the money. Additionally, the tax treatment of structured settlements can vary at the state level.

If you're considering a structured settlement, discussing the pros and cons with a personal injury lawyer and a financial advisor is important to determine the right choice.

Medical Expenses and Settlements

As mentioned, compensation for medical expenses related to physical injuries or sickness is generally not taxable. However, there's an important caveat: if you've deducted medical expenses related to your injury on previous tax returns, and your settlement later compensates you for these expenses, you may need to report this as "recovery of previously deducted expenses."

For example, let's say you paid $10,000 in medical bills in 2022 due to an injury and deducted these expenses from your 2022 tax return. If you receive a settlement in 2024 that includes compensation for these medical expenses, you will need to report this $10,000 as income on your 2024 tax return.

This rule prevents double tax benefits (i.e., deducting the expense and receiving tax-free compensation for the same expense). It's another reason why keeping detailed records of your medical expenses and tax returns is so important when dealing with personal injury settlements.

Emotional Distress and Mental Anguish

The tax treatment of compensation for emotional distress or mental anguish can be particularly complex. As a general rule, settlements for emotional distress or mental anguish are taxable unless they originate from a physical injury or physical sickness.

However, even if the emotional distress damages are generally taxable, you can exclude from your income the amount of these damages that went to medical care for the emotional distress. For example, if you received $50,000 for emotional distress but $5,000 went to counseling sessions, you can exclude that $5,000 from your taxable income.

This is an area where the guidance of a personal injury attorney can be particularly valuable. They can help ensure that your settlement agreement clearly distinguishes between compensation for physical injuries and emotional distress, potentially saving you money on taxes.

Lost Wages and Future Earnings

Settlements often include compensation for lost income or loss of future earning capacity. As mentioned earlier, these portions of a settlement are typically taxable because they're replacing income that may have been taxable if you had earned it through regular employment.

However, you can sometimes manipulate the timing of reporting this income to your advantage. For instance, if you receive a large settlement that includes several years' worth of lost income, reporting this income in a single year can push you into a higher tax bracket. A personal injury attorney can negotiate a settlement structure that spreads this compensation over multiple years, potentially reducing your overall tax burden.

Property Damage and Settlements

As mentioned, compensation for property damage is generally not taxable if it doesn't exceed your adjusted basis in the property. Your adjusted basis is typically what you paid for the property, plus any improvements you've made minus any depreciation you've taken.

For example, if you paid $20,000 for a car, made $5,000 worth of improvements, and then received a $25,000 settlement for its destruction in an accident, you will not owe any taxes on this settlement. However, if you received $30,000 for the car, the $5,000 exceeding your adjusted basis will potentially be taxable as a capital gain.

In property damage cases, it's important to keep detailed records of what you paid for the property and any improvements you made. This documentation can help demonstrate your adjusted basis if questions arise about the taxability of your settlement.

Timing Considerations

The timing of when you receive your settlement can also have tax implications. If you receive a large settlement late in the tax year, it might push you into a higher tax bracket for that year. Sometimes, delaying the settlement until the following tax year might be advantageous.

Additionally, if your case has been ongoing for several years, you can use income averaging to spread the income over several years for tax purposes. This can potentially lower your overall tax burden.

Again, these are strategies that a personal injury attorney can guide you to consider as you negotiate your settlement.

Documentation and Record-Keeping

Throughout this article, we've mentioned the importance of keeping detailed records. This is crucial when it comes to settlements and taxes. You should keep all documents related to your case, including:

• Medical bills and records
• Documentation of lost income
• Correspondence with the other party and their insurance company
• Your settlement agreement
• Any tax returns where you claimed deductions related to your injury

These records can be invaluable if questions arise about your settlement's taxability.

Reach Out to a Personal Injury Attorney Today

If you've received a settlement or are negotiating one, don't leave the tax implications to chance. Reach out to a personal injury attorney today to discuss your case thoroughly. An attorney can ensure you understand the potential tax consequences of your settlement, including how different types of damages are taxed. They can also tailor your agreement strategically to best serve your interests, ensuring effective management of taxable portions. This proactive approach can help navigate the complexities of settlement taxation and maximize the benefits you receive from your settlement.