You've reached the end of your personal injury lawsuit and finally have the award you deserve. Court costs, attorney's fees, medical costs, and other expenses will need to be paid. But what about the IRS?
Most personal injury awards are not subject to federal taxes. The tax treatment of your award will be the same, whether it was reached through trial or settlement. However, personal injury awards are complex and contain both taxable and non-taxable parts.
The portion of your award that compensates you for physical injuries is generally not taxable. Medical bills are perhaps the most significant portion of your award that falls under this category.
Pain, suffering, and emotional distress damages are also not usually taxable. But these must be directly related to your physical injuries. Property damage is another type of award that typically does not get taxed. The IRS views all of these as reimbursement to the victim and so excludes them from federal taxes.
On the other hand, lost wages are taxed. This is an award intended to compensate someone for work that was missed due to an injury. However, had the person not been injured and had earned that money, it would have been taxed. The IRS therefore will tax any portion of damages covering lost wages. Some plaintiffs also deduct out-of-pocket medical costs on previous tax returns. If you wrote off these sorts of eligible expenses in a previous tax year, the compensation you receive for them will likely be taxed.
In some personal injury cases, the court awards punitive damages. These are designed to punish particularly offensive behavior on the part of the defendant. The IRS considers these awards to be in addition to the actual losses incurred by the plaintiff, and so they will be subject to tax.
It's important to understand how exactly your personal injury award is divided up among all of the different types of damages. Failing to make this distinction could subject the entire amount to taxes. Talk to your personal injury attorney so you understand exactly what you have been awarded.
One way to manage personal injury taxes is to use what are called structured settlements. These pay the plaintiff over time instead of all at once, which could lighten the tax burden.
When you've received news of your award or settlement, have your attorney categorize each part. Talk with a tax professional who can provide assistance specific to your situation, and who can also advise as to any tax consequences from your state taxing authority. Tax laws and regulations change every year, so be sure to get the most updated advice from an expert.