Can Personal Injury Settlements Be Taxed by the IRS or California?

Receiving a settlement for personal injury can be a windfall, especially if you’ve incurred large medical expenses as a result of an accident. But before you plan on what you will do with your money, it’s important to know whether or not your personal injury settlement is taxable.

Summary: personal injury settlements are not taxable by California or the IRS; however, compensation for punitive damages, deducted medical expenses, interest on the judgment, and emotional distress may be taxable.

When it comes to the taxability of your personal injury settlement, there’s a general rule and there are exceptions to this rule. The exceptions can get confusing sometimes, so if you’re not sure, it’s best to call a tax attorney for guidance.

If the California Franchise Tax Board or Internal Revenue Service is attempting to tax your personal injury settlement, call Sacramento tax relief attorney Jin Kim at (916) 299-9913 for a free consultation.

Personal Injury Settlements Are Not Taxable

The general rule is that personal injury settlements are not taxable, so long as they arise either from personal injury or from physical sickness. A physical sickness claim is one that’s based on a claim for illness. One example is when you catch a virus at your workplace due to the negligent practice of your employer, and this virus made you sick and unable to work.

Medical bills, lost wages, emotional distress, loss of consortium, and attorney’s fees are all covered by this general rule, so long as the basis for the claim is either from personal injury or from physical sickness.

Exceptions

As mentioned above, the general rule also admits some exceptions. This means that items falling under any of these exceptions are taxable.

Medical Expenses Deducted On Your Tax Return

One exception is when you receive a portion of your settlement for medical expenses. In order for this to be taxable, you must have claimed these medical expenses in your previous tax returns. The portion of the settlement that’s set aside for medical expenses will be taxable insofar as you received a tax benefit from them.

Punitive Damages

Another exception is when you receive punitive damages as a part of your settlement. Punitive damages are awarded in order to punish conduct that is grossly negligent or intentional, with the view of discouraging similar acts. Punitive damages are always taxable. Lawyers typically ask the court to separate the verdict if their client is asking for punitive damages to separate the portion of the settlement that isn’t taxable from the portion of the settlement that is taxable.

Interest

While the sum itself may be non-taxable, the interest on your personal injury settlement is taxable. Interest is usually awarded when the defendant takes a long time to pay from the time the judgment was entered. For example, if a California auto accident lawyer obtained a judgment that was handed down in November of 2020, but the defendant only paid on March 2021, then the interest counting from November to March is taxable.

Emotional Injury Damages

Claims for emotional injury are also taxable. They fall under the exception when the plaintiff claims emotional injury purely without any physical injuries. Emotional injuries include emotional distress or sleepless nights. When there is only emotional injury but no physical injury, then the settlement that you receive is taxable. In order for the settlement to be non-taxable, remember that it should arise from either physical injury or a claim for illness.

Identify Personal Injury Damages

Under some instances you may have two claims; one stemming from a personal injury case and one that does not. In order to ensure that as much of your settlement is non-taxable as possible, you can ask that the line between the two be clearly delineated, otherwise the IRS might assess tax on the entire settlement, including the portion that should be non-taxable. There may be instances where the IRS will challenge the non-taxability of your settlement, but this is one way to ensure that you’re protected.

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Jin Kim

Tax Attorney at Law Office of Jin Kim

Jin Kim is a tax attorney in Sacramento, California. She helps individuals and businesses gain tax relief from the IRS, FTB, CDTFA, and local tax agencies.