How Much Tax Will You Be Required to Pay from Your Personal Injury Settlement?

With Tax Day (April 18th) looming in the not-too-distant future, we thought this would be a good time to discuss the potential tax implications of receiving a personal injury settlement. After all, if you’re awarded a large sum of money as the result of a lawsuit, you should know whether some of those funds will be siphoned away by the government.

Before we get into the particulars, you should know that the information we’re including is based on typical taxation rules that apply to most personal injury settlements. Laws are always subject to change, states vary in their tax regulations, and tax situations differ from person to person. So be sure to verify all factors that might affect your tax liability before filing your annual returns. In other words, it’s essential to consult with your personal tax advisor to be sure you’re observing current rules, regulations and tax laws that may impact your financial circumstances following the receipt of a legal settlement from a personal injury lawsuit.

Let’s Start with the Good News …

 
You’ll be pleased to hear that for both federal and state of Michigan tax reporting purposes, personal injury lawsuit settlements are not generally considered to be taxable income. The Internal Revenue Service spells this out quite clearly in Form 4335, which is a fairly quick read, but you can find more detailed information and resources in this document outlining federal tax rules concerning legal settlements and how the IRS interprets them. Likewise, Michigan has published a 39-page Taxpayer’s Guide which provides comprehensive information on the state’s tax regulations. But for a more reader-friendly description of how the state’s tax laws can impact legal settlements, check out our own web page which quickly spells out how Michigan’s Department of Treasury treats payments received from Personal Injury Protection (PIP) insurance coverage, compensation for lost wages, and disability income paid to a guardian, among other funds that you might be awarded in a personal injury settlement.

You’ll also be happy to know that life insurance, medical insurance and property insurance payouts are also not taxable in most cases. That’s because these payments are made to reimburse you for expenses you’ve incurred, or to help you recover losses due to physical damage to things you own. As a result, these insurance benefits paid to you are not considered to be a form of income unless they exceed the actual amount of the damage or are subject to estate taxes (in which case, you’ll receive a 1099 from the insurance company to use when filing your taxes).

…But There Are Some Exceptions You Should Know About

 
As you may have suspected, you won’t necessarily escape all taxes when you receive a settlement from your personal injury lawsuit. In most cases, the IRS separates personal injury settlements into two categories: (1) non-taxable, compensatory damages and (2) taxable, punitive damages. However, in almost every case, Michigan does not allow for punitive damages. Instead, it has exemplary damages. However, in most cases, the IRS will treat punitive and exemplary damages similarly for tax reasons. For the sake of this article, we will refer to both punitive and exemplary damages as punitive damages (because that is how the IRS will likely treat them). Compensatory funds are intended to compensate victims for their pain and suffering, and to repay them for actual damages they’ve suffered (such as lost wages, medical bills, and rehabilitation costs). As such, compensatory damages are generally not taxable under current law. Punitive damages, on the other hand, are intended to punish the defendant for especially bad actions, malicious behavior, or extreme negligence that caused the plaintiff to be injured. These payments can go far beyond merely reimbursing you for costs you’ve absorbed. As a result, the IRS has determined that, while most compensatory settlements paid to injured parties are not taxable, punitive damages are almost always taxable as income to the recipients. There’s just one exception to prove the rule, which concerns wrongful death lawsuits. In that instance, the IRS spells out its position as follows:

“Punitive damages are not excludable from gross income, with one exception. The exception applies to damages awarded for wrongful death, where under state law, the state statute provides only for punitive damages in wrongful death claims. In these cases, refer to IRC Section 104(c) which allows the exclusion of punitive damages. Burford v. United States, 642 F. Supp. 635 (N.D. Ala. 1986).”

Tax Rules Are Always Changing and Always Confusing

 
To summarize, if your personal injury settlement includes both compensatory and punitive awards, be prepared to pay federal taxes on the latter portion of the money you receive. Of course, that could change tomorrow, so as we’ve already said you should definitely check with your tax advisor before you depend on anything you read on the internet – even this article! For instance, take just a quick look at the blanket disclaimer that kicks off this 37-page document about legal settlement rules that the IRS published on its very own website.

Finally, there are a few more tax matters you also need to understand. While compensation for lost wages you win through a personal injury lawsuit is not taxable, the rules change for other situations where you might be awarded back pay. Specifically, the IRS has determined that “if you receive a settlement in an employment-related lawsuit; for example, for unlawful discrimination or involuntary termination, the portion of the proceeds that is for lost wages (i.e., severance pay, back pay, front pay) is considered taxable and subject to the Social Security wage base and Social Security and Medicare tax rates in effect in the year paid.”

Furthermore, as a Forbes article explains, if you took an itemized deduction for medical expenses on your federal income taxes in a previous year, and are later reimbursed for those costs in a personal injury lawsuit settlement, you’ll have to pay taxes on the amount you claimed earlier as a medical expense deduction. The tax experts at TaxShark also offer insights concerning interest payments you might receive if, for example, you elect to take a long-term personal injury settlement that includes installments paid to you over time. As noted by the IRS, “Interest on any settlement is generally taxable as ‘Interest Income’ and should be reported.” TaxShark goes on to explain that any settlement interest reported to you on form 1099-INT (which also happens to be conveniently shared with the IRS) is considered taxable income and must be reported when you file your federal income taxes.

If That Sounds Confusing, That’s Because It Is — Call Us for Help

 
If dealing with tax questions leaves you scratching your head, don’t fret. As personal injury attorneys, we concentrate on helping clients recover from injuries resulting from car accidents, work-related incidents, nursing home negligence, medical malpractice, dog bites, and many other painful situations. So, while we’re happy to offer general information about the tax implications of legal settlements in this article, we can also recommend dependable lawyers who specialize in matters surrounding taxation. Give us a call at 855-MIKE-WINS (855-645-3946) and we’ll address your specific circumstances and needs – whether they revolve around receiving fair compensation for personal injuries or dealing with the IRS and Michigan Department of Treasury concerning taxes on a legal settlement you’ve received.

Content checked by Mike Morse, personal injury attorney with Mike Morse Injury Law Firm. Mike Morse is the founder of Mike Morse Law Firm, the largest personal injury law firm in Michigan. Since being founded in 1995, Mike Morse Law Firm has grown to over 200 employees, served 40,000 clients, and collected more than $1.5 billion for victims of auto, truck and motorcycle accidents. The main office is in Southfield, MI but you can also find us in Detroit, Sterling Heights and many other locations.