Compensation for physical injuries recovered in a personal injury lawsuit is not taxable under state or federal laws. This includes compensation awarded by a verdict or compensation awarded as part of a settlement agreement. Damage awards are excluded from an individual’s gross income, including compensation awarded for pain and suffering, loss of consortium, loss of income, medical expenses, and attorney fees.
Punitive Damage Awards & Interest Are Taxable
Punitive damages awarded by a judge or jury are considered taxable income. For this reason, a plaintiff’s personal injury lawyer will typically request that punitive damages be separated from compensatory damages. This makes it easier for plaintiffs to show the IRS and state tax authorities precisely how much of the total compensation is taxable. Punitive damages must be reported as “other income.” It is important for recipients to pay this right away, otherwise interest and penalties can add up quickly.
Interest awarded on the judgment is also taxable. Interest may be awarded starting from the date that the lawsuit was filed with the court. The interest calculation can run until the defendant exhausts appeals and the payment is made in full to the plaintiff. Taxpayers should keep in mind that it is only the interest that is taxable and not the full settlement amount.
Lost Wages or Profits May Be Taxable
Compensation awarded for involuntary termination, lost income, back pay, and severance pay may be subject to social security and Medicare taxes. Compensation for loss of profits for a business is considered net earnings and is thus subject to self-employment taxes. Individuals are required to declare this income as business income and provide all necessary documentation to support the amount owed and the amount paid.
The IRS Can Challenge Claims of Non-Taxable Status
The IRS can and does challenge claims of non-taxable compensation. This is why it is crucial for recipients to have sufficient supporting documentation that establishes the award or settlement falls within IRS guidelines for tax-exempt status. The stronger the documentation, the stronger the case for excluding the income from taxation.
As a general rule, most personal injury settlements are not taxable. However, it is always advisable for recipients to meet with a certified accountant before spending any compensation received. This can ensure prompt payment of any taxes due and avoid any nasty surprises when tax day rolls around.