Tax Consequences of your settlement, arbitration award or judgment

As a personal injury attorney, I am fortunate to help my clients receive compensation for injuries. While no amount of money can return them to their pre-accident status, the money does help them adjust to their new “normal.” A frequent question that I am often asked is how does receiving a settlement, arbitration award or a judgment effect their taxes. 

At Major Law Firm we pride ourselves on helping our clients get the most money possible after a car accident, a construction accident or an 18-wheeler accident. In Texas we are fortunate to live in a state with no income tax at the state level. However, on the federal level we are not as fortunate. Under § 104(a)(2) of the InternalRevenue Code, damages, other than punitive damages, received for physical injuries or sickness are excluded from gross income. In other words, damages for physical injures will not be taxed but other damages will be. There is a presumption under the law that recoveries are taxable. Damages for nonphysical injuries do not qualify for the § 104(a)(2) exclusion and thus are taxable. Federal tax law treats monies received from a negotiated settlement, an arbitration order or a formal court judgment the same.

Recoveries received may alternatively be excluded from income, treated as ordinary income to Plaintiff, treated as capital gains resulting from the sale or exchange of an asset, or treated as a return of capital in the plaintiff’s asset. The tax treatment of the recovery is determined by reference to the underlying claim. The SupremeCourt has called this the “origin of claim test.” Compensatory damages for personal physical injury or sickness are generally excluded from Plaintiff’s income. However, recoveries for economic injuries, such as lost wages, emotional distress and punitive damages are taxable as income. Interest paid on personal injury is taxable as gross income, even if the damages are excluded from taxation.   

Monies awarded for emotional distress or mental pain and anguish are considered gross income. The Internal Revenue Code defines emotional distress as temporary physical symptoms like insomnia, headaches, and stomach disorder. Damages for loss reputation under libel, slander, and malicious prosecution are taxable.  

Workers’ compensation money is excluded from gross income. But amounts that are received as compensation for an on occupational injury or sickness are taxable. State law determines whether the workers’ compensation monies are taxable. If the worker’s compensation statute provides for recovery of lost wages or other benefits, as a substitute for a pension or other compensation, the IRS treats recovery under that statute as taxable.  

Recoveries from wrongful death claims, other than punitive damages, are not taxable. However, federal estate taxes may be involved.  

Generally, recoveries for past and future medical expenses may be excluded from income under internal revenue code § 104. The IRS will generally look at the allocation in a settlement agreement indicating the amount of the settlement that is recovery for past medical expenses, unless the allocation is unreasonable. If there is no allocation in the settlement agreement the IRS will include as income the portion of the recovery that equals all medical expenses presented in the case that were previously deduced.