Being the victim of someone else’s negligence is hard enough. However, when you throw in expenses like medical bills and repairs, the situation becomes even more insurmountable. Luckily, the state is at your side and recognizes your pain and suffering.
Personal injury settlements relieve stress and ease frustration, as the culprit will finally reimburse your losses. While money can’t fix everything, it can bring you financial relief in challenging times like these. However, most people get excited over the results of their cases and don’t stop to ponder this critical question: “Are personal injury settlements taxable?”
The answer to this isn’t as black and white as most would like, but this blog post will help you better understand how personal injury settlement tax works.
The Basics of Personal Injury Settlements Taxes
According to the Internal Revenue System (IRS) Section 104, federal and Colorado state laws, generally, personal injury settlements are non-taxable [1]. The theory behind this personal injury settlements are not payments you earned but compensation for losses endured through the accident. In many instances, people involved in a personal
However, there are some exceptions in which the lines blur, so your settlement may not be completely tax-free.
Here’s a breakdown on taxable personal injury settlement taxable:
- Non-Taxable: Physical illness, injury, property damage/loss, pain and suffering
- Possibly Taxable: Emotional distress (depends on connection to physical injuries)
- Taxable: Punitive damages, lost wages
Types of Non-Taxable Settlements
In most cases, your personal injury settlement compensation will be non-taxable because the compensation was not related to labor you provided. Instead, the personal injury settlement you receive is meant to replace the funds you lost due to injuries sustained in the accident or property damaged by the perpetrator.
That being said, there are numerous types of non-taxable personal injury settlements, some of which you may or may not be aware of.
Physical Injury or Sickness
Generally, settlements or awards received for physical injuries or illnesses are non-taxable. This includes compensation for medical expenses, pain and suffering, and other damages resulting from the injury or illness. This might also include compensation for medical treatments, rehabilitation, or lost wages due to injury or illness.
Emotional Distress
If the settlement is for emotional distress arising from a physical injury or sickness, it is usually considered non-taxable. In many cases, people equate this to pain and suffering, but emotional distress can include much more than that.
For example, PTSD caused by the injury can lead to extreme emotional distress and incur many expenses for treatment and medications. A person may undergo changes in relationships or lose enjoyment of life as a result.
Emotional distress can also include the psychological toll that a loss of independence from long-term injuries can cause. It may lead to lower income earning potential, an inability to engage in recreational activities a person once enjoyed, and more.
In most cases, a judge will put a price on these things, and the payout won’t be taxed.
Wrongful Death Claims
When a person dies due to someone else’s carelessness, such as rash driving, unskillfulness, or criminal intent of an entity or some other person, the deceased’s family has the right to file a wrongful death lawsuit in court.
Wrongful death claims are non-taxable because they fall into the criteria of personal injury that led to the death. Implementing taxes on this settlement would add to the potential burden instead of relieving grieving family members in these challenging times.
Workman’s Compensation
Another element that falls into the non-taxable settlements category is work-related injuries. Worker’s compensation, also known as workers’ comp or workman’s compensation, is an insurance program designed for the welfare of injured employees.
It’s not necessary that to avail this claim, the injury had to occur at the workplace. For instance, you can be out in the field running some work-related errands or are traveling for work purposes, and if something unfortunate happens, your company will cover the cost as part of the compensation.
Workers sometimes develop chronic back problems and stress fractures due to long work hours. Others might develop medical conditions, like heart problems, lung disease and other diseases as a result of exposure to harmful chemicals at their workplace.
According to Colorado’s Workers’ Compensation Act, these things come under the physical suffering and are not liable to tax as these benefits are in place to help the injured workers with their pain and anguish rather than serving as an additional income or a gain [2]. The claim acts as a safety net for workers, ensuring they’ll receive the necessary financial support if an unfortunate event happens.
Types of Taxable Settlements
As we previously mentioned, not everything related to taxes on personal injury settlements is black and white. Below are just some examples of instances where the government has decided a personal injury settlement tax makes sense.
Social Security Disability
Under the Social Security Amendment Act 1983, disability benefits are liable to tax if the gross income passes a certain threshold.
For instance, if you’ve other income streams like (self-employment, dividends, and pension) along with Social Security Disability Insurance Benefits (SSDI), the IRS calculates the combined income by adding one-half of the disability benefit to other household income.
To be tax-free, your income must fall under the $25,000 bracket for single filers and $32,000 for married people. The tax is applicable if the threshold surpasses the above-stated income bracket.
To calculate, you can use the SSA-1099 annual form, which highlights the social security benefits you received last year. Use the 1099 for settlement payments along with the rest of your income and determine whether you’re subject to tax.
Settlements for Lost Wages
Settlements for lost wages are taxable because they’re the money you’d have earned during your work if not hindered by the injury. The settlements act as a substitute or replacement income and therefore are taxable.
Criminal Justice Awards
Criminal justice awards free of injury will be considered liable to tax by the IRS. For example, if your store is damaged during an armed robbery, and a settlement is provided to fix it, it’s subject to taxation as, according to Internal Revenue Code (IRC), these awards are considered income.
Exceptions Where Personal Injury Settlements Are Taxed
As you’ve seen already, there are some clear-cut instances for both non-taxable and taxable personal injury settlements. However, there also some aspects of personal injury settlement tax law (like the examples listed below) where things aren’t quite so black and white. These are known as “exceptions to the rule,” and having them on your radar before you settle is beneficial.
Taxable Punitive Damages
The court offers punitive damages to the defendant for outrageous, heinous, or harmful conduct. Since they act as a punishment for the wrongdoing rather than compensation for victims’ loss, these funds are taxable as they are categorized under other sources of income on your tax return.
Settlement Interest
If you’ve invested in a personal injury settlement somewhere, the return you’re getting as interest is subject to taxation as it’s your source of income.
Emotional Distress
If you’re suffering from mental anguish, emotional distress, defamation, and humiliation but not on account of physical injury, the compensation is taxable. For instance, if the dog chases you at the park, and you develop an anxiety disorder after the event, the settlement is subject to taxation. Similarly, if you came under fire due to discrimination, compensation is also subject to tax.
However, on the other hand, if you suffered a car accident and have developed PTSD after it or require counseling sessions, the compensation is tax-free as it’s on account of physical suffering.
How the IRS Collects Settlement Taxes
To understand this, it’s crucial to factor in the type of settlement you received, IRS laws on it, and the recipient’s overall income. As noted, some of the settlement is taxable, but it depends on the nature of the claim you’ve filed for.
Generally, as with any income, the IRS collects settlement taxes also at the time of tax return for the preceding year. The form 1099 for settlement payments is utilized to quote the amount that is subject to tax.
Factor in the compensation in physical harm and non-physical categories. If it’s for physical injury, there’s no need to mention it on the other income in your tax filing, but if it falls in the non-physical category, quite the amount for fair treatment. A wise thing would be to consult your advisor and gain expert insights before filing taxes.
Minimizing Your Tax Liability from a Personal Injury Settlement
Nothing is easy when it comes to personal injury settlement taxes, especially when you’re already dealing with the physical and emotional toll of your accident. Luckily, partnering with a personal injury lawyer can be beneficial in minimizing your tax liability from a personal injury settlement through strategic planning and structuring of the settlement.
The team at Legal Help in Colorado knows the ins and outs of Colorado personal injury law, so we can help you maximize your settlement without increasing the tax buden of it all.
When you work with our legal team, we will ensure that the settlement allocates a significant portion of the damages to non-taxable categories, such as physical injuries, medical expenses, and emotional distress directly linked to bodily injury or sickness. By clearly delineating these non-taxable elements, we can minimize the portion of your settlement subject to taxes.
Also, we will properly document the non-taxable elements of your settlement to substantiate your position with tax authorities. Gathering the necessary evidence and documentation to support your claim takes time, but we’re here to help you get it done.
Want to learn why the team at Legal Help in Colorado was voted the #1 personal injury law firm in Denver and maximize your non-taxable personal injury claim? Contact us today to get started.
Resources
[1] https://www.irs.gov/government-entities/tax-implications-of-settlements-and-judgments
[2] https://cdle.colorado.gov/workers-compensation-act