After an accident, a personal injury settlement is supposed to help compensate an injured party for any lost income or damages — but what happens when that amount gets taxed, and you’re left to cover any remaining costs?
Here, we’ll explain the situations in which this may happen, as in any situation, your settlement’s tax treatment will vary depending on several factors. We’ll also explain the difference between basic terms like compensatory and punitive damages, qualified and non-qualified settlements and more.
Of course, if you’re still unsure whether your personal injury settlement is taxable, the best thing to do will be to reach out to a qualified attorney. Singh Ahluwalia Attorneys at Law are here to help, and can provide a confidential and no-obligation case review to discuss all your options. All you have to do is call (559) 878-4958 or contact us online to schedule your appointment today.
Are Compensatory and Punitive Damages Taxable?
Compensatory damages and punitive damages are two types of monetary awards that may be included in personal injury settlements. Below, we’ll dive deeper into how these damages differ and whether or not they are considered taxable in California.
What Are Compensatory Damages?
Compensatory damages are awarded to the injured party to compensate for the losses they have incurred as a result of the injury or accident. These damages aim to restore the injured person to the position they would have been in had the incident not occurred. Compensatory damages typically cover medical expenses, property damage, lost wages, and pain and suffering.
Are Compensatory Damages Taxable?
In general, compensatory damages received in a personal injury settlement are not considered taxable income for federal tax purposes. This means that if you receive compensatory damages as part of your settlement in California, you do not have to report them as income on your federal tax return.
Moreover, California does not conform to the federal tax treatment of compensatory damages, so you can count on further protections here.
In California, compensatory damages received for personal physical injuries or physical sickness are not taxable for state tax purposes. This means that if you receive compensatory damages specifically for physical injuries or physical sickness in California, you will not have to report them as taxable income on your state tax return.
What Are Punitive Damages?
Punitive Damages are not meant to compensate the injured party but rather to punish the at-fault party for their misconduct and deter others from engaging in similar behavior. Punitive damages are awarded in cases that proceed to trial where the defendant’s actions are deemed by a jury to have been especially reckless, malicious, or intentional.
Are Punitive Damages Taxable?
Unlike compensatory damages, punitive damages are generally treated differently for tax purposes. Both at the federal and state level, punitive damages are considered taxable income. If you receive punitive damages as part of your personal injury settlement in California, you will be required to report them as taxable income on both your federal and state tax returns.
Are Other Elements in a Personal Injury Settlement Taxable?
In addition to punitive damages, any interest accrued on a settlement may also be taxable.
For example, imagine the hypothetical plaintiff ‘John’ decides to pursue a personal injury claim against a negligent driver who caused a severe car accident. After negotiations and legal proceedings, John successfully reaches a settlement agreement with the at-fault driver’s insurance company. The settlement includes compensation for his medical expenses, pain and suffering, lost wages, and an additional amount of interest that accrued on the settlement funds.
In this case, the interest portion of John’s settlement is considered taxable income. Suppose the settlement amount is $100,000, and the accrued interest amounts to $5,000. John would then need to report this taxable interest on his federal tax return.
How to Report Taxable Interest On Your Federal Tax Return
Let’s continue this example with our hypothetical plaintiff John. In the following step-by-step scenario, here’s how John would report the taxable interest to the IRS.
- Form 1099-INT: John should receive a Form 1099-INT from the insurance company that provides details of the interest earned. This form is sent to both the taxpayer and the IRS.
- Reporting the Interest: John needs to report the taxable interest on his federal tax return using Form 1040. The interest amount of $5,000 should be reported on Schedule B, which is used to report interest and dividend income.
- Completing Schedule B: On Schedule B, John would provide the required information regarding the payer of the interest, the total interest received, and any related expenses or adjustments. The interest income is typically entered on line 2, “Taxable interest.”
- Transfer to Form 1040: Once the information is provided on Schedule B, John would transfer the taxable interest amount of $5,000 to the appropriate section of Form 1040. The interest income is generally included in the total income reported on line 1, “Income.”
Of course, each taxpayer’s situation may vary, and the reporting requirements may change based on your individual circumstances. Your personal injury attorney can help you identify whether any part of your settlement will be taxable down the line.
What Are Qualified Settlements?
Qualified Settlement Funds (QSFs) are financial arrangements that can offer tax advantages in personal injury settlements.
A qualified settlement fund (QSF) is a legal and financial arrangement that holds and distributes settlement funds in a personal injury case, while a personal injury settlement refers to the resolution and compensation reached between the injured party and the at-fault party or their insurance company. Here’s a better breakdown of how the two differ:
Qualified Settlement Funds
A QSF is established to facilitate the settlement process. It acts as a temporary holding account for settlement funds, allowing for the orderly distribution of funds to the appropriate parties.
The funds held in a QSF are specifically designated for settlement purposes. They represent the agreed-upon compensation amount intended for distribution to the injured party or other beneficiaries.
Personal Injury Settlement
A personal injury settlement is the final resolution reached between the injured party and the responsible party or their insurance company. It determines the compensation amount and terms to address the damages suffered by the injured party.
Tax Considerations for Qualified Settlement Funds
One of the key advantages of a QSF is the potential tax deferral it offers. By placing the settlement funds into a QSF, the tax liability can be deferred until the funds are distributed from the QSF.
Additionally, while held in the QSF, these funds can be invested, and potentially generate additional earnings. That said, similar to any interest accrued on a settlement, these investment earnings are generally taxable when distributed.
The tax liability on the funds held in a QSF arises when they are distributed to the injured party. At that point, the distributed funds are considered taxable income.
What Are Structured Settlements?
Structured settlements are essentially the same as traditional personal injury settlements but divided into periodic payments. There, the total settlement amount is paid out over a predetermined period of time, often in the form of ‘annuities.’
One significant advantage of structured settlements is the potential for tax exclusion. If the structured settlement meets specific requirements outlined in the tax code, the periodic payments received by the injured party are generally tax-free. This means that neither the principal nor the investment earnings are subject to income tax.
In this way, structured settlements can provide tax savings compared to receiving a lump sum payment, as the periodic payments are not considered taxable income.
What Are Non-Qualified Settlements?
Non-qualified settlements refer to personal injury settlements that do not meet the specific criteria to be considered qualified settlements or structured settlements.
In non-qualified settlements, the entire settlement amount, including any compensatory damages, interest, or punitive damages, is generally taxable income. These amounts must be reported as income on both federal and state tax returns.’
The injured party should receive appropriate tax documentation, such as Form 1099-MISC or Form 1099-NEC, from the payer of the settlement. This documentation outlines the taxable portions of the settlement that need to be reported on the tax returns.
Given the complexities surrounding non-qualified settlements, it’s usually best to consult with your attorney if you suspect that your personal injury settlement might include a non-qualified settlement.
What Other Situations May Affect the Taxability Of My Personal Injury Settlement?
While uncommon, there are a handful of other situations that can also complicate whether or not your settlement can be considered taxable.
For example, In the unfortunate event of a wrongful death, i.e. when a personal injury claim arises from a death caused by someone else’s negligence or misconduct, the tax treatment of the settlement may differ. Thankfully, any compensation received in wrongful death claims is generally not considered taxable income, but you’ll want to consult with your attorney to confirm this is the case for your specific settlement.
Conversely, settlements related to employment claims, such as discrimination, harassment, or wrongful termination, may have unique tax considerations. In most cases, the portion of the settlement allocated to lost wages, back pay, or severance may be subject to income tax. However, damages awarded for emotional distress or other non-economic harm may not be taxable if they result from a physical injury or physical sickness.
Speak to an Experienced Personal Injury Attorney for More Guidance
It’s always best to consult with your attorney before trying to decipher the taxability of any settlement. Luckily, the team at Singh Ahluwalia Attorneys at Law is here to help, and can quickly explain whether or not your specific settlement will be taxable. To schedule your first confidential, no-obligation tax review with their team, simply call (559) 878-4958 or contact us online to schedule your appointment today.