Personal injury cases can take months; even years to finally resolve. However, the stress doesn't always end after finally receiving compensation.
There are many instances where the defendant is subject to income tax that applies to a personal injury settlement. One of the most frequently asked questions is whether or not the defendant has to pay taxes on settlements. The good news is that most money received is typically non-taxable.
Let's look at some cases where you may have to pay taxes and how to protect your settlement from the IRS.
Suppose you're awarded compensation based on physical injury or illness. In that case, you do not have to report the settlement as income to the IRS.
If you receive a taxable award with punitive damages, you must report it as income on your tax return. It's also advised that you report lost wages gained and any interest in a settlement. In taxable circumstances, lawyer fees are considered part of your award. This means the IRS can tax you for the entire award amount.
It's always best to consult with an attorney and an accountant when going through a personal injury case. An experienced attorney will help structure your settlement and tax agreements to reduce tax liability.
Generally, the IRS will not tax you on settlements won in a personal injury case. This is because the compensation you receive in a settlement is intended to reimburse for economic losses like injury and expenses.
The factors that determine if it's tax-exempt or table are categorized as:
Damages are the emotional and mental stress related to the injury or sickness. Punitive damages are intentionally made to penalize the party at fault. Punitive damages are rare and not meant for compensation for a loss. Still, defendants can be awarded on top of the compensatory damages.
It's important to note that the IRS says this is "not a hard and fast rule." Many of the rules will depend on the origin of the claim and your unique case. An experienced personal injury lawyer will help explain damages, how they were calculated, and what categories those damages fall into for compensation.
The IRS typically looks at the language in the settlement agreement when determining whether it will be tax-exempt or not.
The portion of your settlement awarded for physical illness and injuries is considered non-taxable.
Here are a few examples of cases where settlements are non-taxable:
Wrongful death cases
However, there are exceptions to this rule. For example, even if you have suffered physical illness or injury, you can be taxed on damages related to a breach of contract.
If you receive punitive damages in your personal injury settlement, they will be taxed.
This applies even if it's directly tied to physical illness and injuries. You will report punitive damages as "Other Income" on your federal Form 1040.
It's also a general rule of thumb that interest on any type of personal injury settlement is considered taxable. This is reported as interest income on your Form 1040.
In many states, if a portion of your settlement was taxable on your federal taxes, then it's also taxable on your state taxes.
Even when an accident causes emotional distress and physical symptoms that cannot be seen, such as stomach aches and headaches, the IRS can tax your settlement.
It's best to consult with an experienced attorney and provide details of all physical and emotional distress. Then, they can help categorize damages to help avoid taxation.
Depending on your unique case and the compensation received, a portion of the settlement may be taxed like income.
How much the IRS takes in personal injury settlements depends on several factors like the origin of the claim and your tax bracket – which can change after a settlement.
Settlements are not subject to a special tax rate, so they will likely be taxed on ordinary income. Remember that the IRS takes the entire amount that was initially awarded into consideration. For example, if you were awarded 200,000 and your legal fees added up to 50,000 – the IRS would tax you based on 200,000.
Suppose you're receiving compensation from a personal injury case. In that case, you need to take specific steps to protect the award you're given. Protecting this settlement means a creditor cannot file a lien against it, even if you declare bankruptcy.
To help protect your awarded settlement, it's vital that you separate that money from all other wages earned. This means depositing your money into a separate segregated account and never depositing any other money into that account. If you mix your money, it removes the exemption for this compensation.
The IRS can constantly challenge the non-taxability of your settlement. However, by allocating your settlement, you have the best chance of maintaining exclusion.
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