In most scenarios, the answer is no, you won't need to pay taxes on your personal injury settlement, at least to the extent that the amount you receive is meant to compensate you for injuries suffered. That's the general rule, and it should come as no surprise that there are some exceptions to it. Read on for the details.
A Settlement for Injury or Illness Will Be Tax-Free
The federal income tax code specifically excludes from one’s gross income the amount of any damages received, both by lawsuit or by settlement, as long as the proceeds of the lawsuit or the settlement are for personal physical injuries or physical sickness. For more details on the federal tax implications of a personal injury settlement, see the IRS publication Settlements - Taxability (from IRS.gov).
All state tax codes follow the federal tax code's lead on this issue. So you don’t have to pay federal or state income taxes for a personal injury settlement.
A Punitive Damages Award Is Taxable
One exception to the non-taxability of injury lawsuit proceeds is when compensation comes in the form of punitive damages, which are paid by the defendant as punishment for particularly outrageous or egregious conduct, and which are meant to deter others from similar conduct.
If you win an award in a personal injury lawsuit, you are going to have to pay taxes on any funds meant to cover punitive damages, while the funds meant to cover your injuries will remain tax-free. The good news here is that if you have to pay taxes on a punitive damages award, you are permitted to deduct any attorney's fees that relate to the punitive damage award. So, if you are awarded $100,000 for punitive damages, and you have a standard 1/3 contingency fee agreement with your lawyer, you can deduct $33,333.33 in attorneys fees relating to the punitive damage award.
What About a Punitive Damages Settlement?
It's pretty clear that, if you get a punitive damages award, it's going to be taxable. But what about a settlement? This is where it gets a little murky. The bottom line is that, if you settle a personal injury case, you theoretically will have to pay taxes on any part of the settlement that is meant to cover a punitive damages claim.
Some lawyers, cognizant of this rule, will write up the settlement documents to emphasize that the entire settlement is for your personal injury claim, and that no part of the settlement is intended for punitive damages. That sounds pretty simple, right? But as unlikely as it might be, if the IRS were ever to find out the details of your settlement, the agency is entitled to "reallocate" the settlement moneys to reflect what the settlement actually covered.
Let’s look at an example of this. Say that you settled your case for $1,000,000, and that you had a very, very strong punitive damages claim, even stronger than your personal injury negligence claim. But the settlement agreement simply said that you received $1,000,000 for your injuries. The IRS could argue that, in reality, $600,000 of the settlement was for your punitive damages claim and only $400,000 of the settlement was for your injuries. So, you want to have your lawyer write up the most airtight settlement agreement possible. The settlement agreement should allocate the settlement funds solely to the personal injury claim and it should give a good explanation for why the settlement agreement is not allocating anything to punitive damages.
Believe it or not, there is an exception to this punitive damages exception, and it applies in those states that only permit the recovery of punitive damages -- no standard negligence-based damages -- in wrongful death claims. In other words, all wrongful death damages are categorized as “punitive damages” in those states. The result is that for those states only (Alabama is one example) punitive damages recovered in wrongful death claims are not taxable.