How Does the IRS View Your Settlement?
Of course, here in Texas, we have no state income tax. The federal government does tax income, and when someone recovers a large sum of money from a lawsuit or settlement, they may wonder if they owe Uncle Sam his cut. Usually, but not always, the answer is no.
The IRS has a general rule covering the taxability of settlements and lawsuits in Section 104 IRC (the Internal Revenue Code). It excludes compensation received for personal injury and physical injury cases.
Judgments and settlements are typically separated into specific groups to determine whether the money received is taxable or non-taxable. Two groups compensate victims for injuries, and the third group punishes offenders.
Generally, settlements will fall into one of these three categories:
- Actual Damages: These can result from physical or non-physical injury.
- Emotional Distress Damages: This can either constitute physical or non-physical injury.
- Punitive Damages: Typically they punish inappropriate/dangerous behavior and do not compensate for an injury.
Personal Injury Cases: The Exception to the Rule
It all depends on the circumstances involved with each settlement. But clearly, the IRS does deem settlements that include what they consider “observable bodily harm” as non-taxable money. So, visible injuries are one fact and circumstance that would allow you to keep your settlement intact.
In many personal injury claims, emotional distress may be a significant factor. It becomes tricky when it comes to what the IRS can and cannot tax regarding your settlement.
Emotional distress is not a physical injury. So, if you received a monetary settlement for emotional distress, the IRS would tax it. However, if you had to seek medical attention for emotional distress, the IRS might not tax it.
The IRS can consider emotional distress damages non-taxable in these situations.
- If your distress came about from the actual physical injuries that you suffered, you will likely not have to pay taxes on it.
- The IRS will consider if you have to seek medical attention, such as counseling services or psychology sessions, basically anything that shows that it is taking a physical toll on you. This makes it more of a physical injury than a simple state of mind or perception of stress.
Are Wrongful Death Settlements Taxable?
When a person receives a wrongful-death settlement, it is usually a large amount of money. When a person is awarded this type of compensation in a settlement, they often wonder if they must pay taxes on it.
Because of this certain monetary award, the IRS will typically not tax it. After all, a wrongful death settlement comes because of observable, physical harm. The person is no longer alive. Therefore it is a visible injury.
Depending on whether your settlement was punitive or compensatory, the IRS will determine what parts of the settlement to tax. Compensatory damages are given to a person to compensate for their losses. Punitive judgments are a little bit different. They usually punish specific, unacceptable behavior. Since punitive damages do not compensate for visible or physical loss of life, the IRS can tax it.
Another aspect of this to consider is that, in some cases, state laws have something to do with it. All the IRS determines is what is taxable and what is not. For example, certain states will only allow punitive damages in wrongful death cases. And in those states, they may or may not be exempt from taxes by the IRS.
In the end, it all boils down to what compensation you received for the actual physical injury or illness. Remember that any compensation for the visible physical injury suffered by the victim is usually tax-free.
Submitting the Right Information to the IRS Regarding Your Settlement
Talk to your attorney as well as your tax preparer (or accountant) about all of these crucial details. Filling out everything correctly and using the correct language will determine your tax burden.
This is why it is so important to have the right lawyer on your side. They can help you by answering any questions regarding your settlement and advising you on how to proceed with the IRS after you collect the money. Contact a personal injury attorney today to learn more.