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Is My Personal Injury Settlement Taxable or Not Taxable?

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Is My Personal Injury Settlement Taxable or Not Taxable?

It is tax time once again.  The Rockafellow Law Firm is not in the business of giving tax advice, but there is one area of tax law that we are familiar with and give clients advice on in every case:

That is: “Are personal injury settlements taxable as income?”

The short answer is no, but as with most areas of the law, there are exceptions:
Section 104 (a)(2) of the Internal Revenue Code states: “Amounts received as damages on account of physical injuries or physical sickness are excludable from income:”

Here are the exceptions:

A: Punitive damages meaning damages not meant to compensate the injured person but to punish the wrongdoer. Compensatory Award: $100,000: Not taxable: Punitive Award: $100,000: taxable.

B: Interest on awards:  Assume a judgment for $100,000 is entered in your favor for physical injuries or physical sickness:  the judgment gets appealed and earns $5,000 in interest by the time the appeal is over.  The $100,000 is not taxable, but the $5,000 in interest is.

C:  Damages for emotional distress are taxable BUT: payment of medical expenses for the treatment of emotional injuries is not taxable. Award of $100,000 for emotional injuries: taxable: Award of $10,000 for treatment of the emotional injuries: not taxable.

D:  Back pay for employment discrimination is taxable as it does not arise out of a “physical injury or physical illness:”

E:  Income lost as a result of a personal injury or physical illness and later reimbursed in an award is not taxable.  If your award includes $10,000 for the inability to work because of your injury or illness, that part of the award is not taxable.  This includes income derived from an income replacement insurance policy or disability insurance policy and even Workman’s Compensation awards.  “Overhead Replacement” Insurance policies are taxable.

Most general releases do not sort out damages paid for specific claimed losses but refer to “Damages on account if physical injury and/or illness.”  This covers the broad topic under section 104(a)(2) referred to above and makes the award a tax-free event.

1099 forms are not provided to the injured person. They are instead provided to the law firm as attorney’s fees earned by the law firm are taxable.  The issued 1099 is for the gross amount of the settlement or award.  The IRS then applies its “assumption test” to determine if the law firm is adequately reporting income from personal injury settlements.  No 1099 to the injured person means the injured person does not have to claim the settlement proceeds as income.

As always, of course, consult your tax professional but rely on the fact that your personal injury damages award is a nontaxable event.  This is one the few “gifts” left in the tax code.  Use It.

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