It’s great when I’m actually able to recover money on behalf of one of my clients, either through settlement or judgment. However, one client recently inquired whether such money might be taxable. Thus, this blog post. The quick answer? As with most legal concepts, there is no quick answer.
The IRS has a helpful publication, Publication 4345 (http://www.irs.gov/pub/irs-pdf/p4345.pdf), which clarifies the issue from the federal perspective. Generally speaking, whether the money is taxable depends on what the money is intended to compensate for.
- If the money is for personal, physical injuries or sickness, or for mental anguish related to those physical injuries, the money is generally not taxable. The exception comes up if you itemize your deductions (Schedule A) and were able to include a deduction for medical expenses related to the injury. Thus, in most personal injury cases, the money is not taxable.
- If the money is for lost wages, the money is taxable. Thus, in most employment cases, the money is taxable.
- If the money is for loss in value of property, the money is usually not taxable. So if you were in a car crash and some of the money is for replacement of your car, that’s not taxable.
- Punitive damages are taxable as ordinary income.
- If you receive real property or tangible things (not money) as part of a settlement, such as in a divorce, this can have complicated tax issues regarding whether the value of such items is taxable.
So the general rules: personal injuries and loss of value of property, no; lost wages or punitive damages, yes; other payments, maybe.