At the end of a Personal Injury case, I frequently hear a common question — Do I have to pay taxes on the money I am receiving?  Thankfully, the answer is usually no.  Personal Injury recoveries are one of the few exchanges of money in the United States that do not result in a tax bill.

The General Rule About Income and Taxes
In the United States, nearly all exchanges of money result in tax consequences.  The Tax Code provides that all income is subject to taxation.  Accordingly, whenever someone receives money, it almost always leads to a tax bill.

The Rule About Personal Injury Recoveries 
Fortunately for people injured in accidents, there is an exclusion in Section 104(a)(2) of the Tax Code providing that income does not include “the amount of damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”

This exclusion makes Personal Injury settlements and verdicts tax free.  So, all monies received as compensation in a Personal Injury case, including amounts for lost wages, medical bills, other expenses and pain and suffering are exempt from taxation.

This exclusion only applies if there are physical injuries; emotional distress alone is not sufficient.  Even if the emotional distress results in related symptoms — like insomnia, headaches and stomach disorders — it would not qualify as a “physical injury” under the income tax exclusion.  So, settlements or awards from cases in which the injured party suffered emotional distress, but without physical injuries, are subject to income taxes.

Exceptions for Punitive Damages and Confidentiality Clauses
As the Tax Code specifically states, Punitive Damages are not exempt from taxation.  Punitive Damages are meant to punish and deter the defendant rather than compensate the injured party for physical injuries.  As such, Punitive Damages are taxable.

In addition, if the settlement of a Personal Injury case calls for confidentiality of the settlement terms, the portion of the settlement proceeds allocated to that confidentiality provision is taxable.

This entry was posted on Tuesday, July 1st, 2008 at 8:04 am and is filed under Civil Litigation. You can subscribe via RSS 2.0 feed to this post's comments. You can comment below, or link to this permanent URL from your own site. Your comments will appear immediately, but I reserve the right to delete innapropriate comments.