With tax season almost upon us, some of our clients might be wondering whether they need to claim their car accident settlement on their tax returns. And if so, how much can they expect to pay in taxes on their settlement?
Generally, you will not need to pay any taxes on your auto accident insurance settlement. As is often the case with tax law, there are exceptions to the general rule. Everything will depend on what types of losses you received compensation for in your settlement. Most often (if you did not take an itemized deduction for the specific injury in previous years) settlements from physical injuries and sickness are non-taxable. This should save you a considerable amount of money, allowing you to use the entirety of your settlement for getting back on your feet. Let's run down through the most common types of damages awarded, but first we'll look at the applicable Internal Revenue Service (IRS) rule below.
The Relevant IRS Rule
You can find the applicable IRS rule regarding taxation of settlements and court judgments at 26 C.F.R. 1. We won't reprint the law here but will instead summarize some of the main points as they relate to car accidents:
- You can exclude from your gross income any damages you received on account of physical injuries or sickness. Typically, this includes compensation for medical care as well as for pain and suffering.
- Punitive damages are not excluded but must be counted.
- Damages for emotional distress are not excluded; however, they will be if they are attributed to a physical injury or sickness.
To determine how much of your settlement is taxable, you will need to look at why you received money in your settlement.
Compensation for Medical Care
Physical injuries are the primary reason many people bring a lawsuit or seek a settlement from the at-fault driver. These injuries can cause a victim to incur tens of thousands of dollars in medical care, if not more. When injuries are serious, victims might need medical care for years into the future.
As part of a personal injury settlement, you can receive money for out-of-pocket medical expenses, such as the following:
- Hospital stays
- Doctor's visits
- Prescription drugs
- Over-the-counter medication
- Assistive devices (like crutches or a wheelchair)
Damages for medical care should be based on your out-of-pocket medical bills and any anticipated future medical treatment. The amount you receive for medical treatment is excluded from your income according to the IRS, so you will not need to pay income tax on it.
Compensation for Pain and Suffering
Physical injuries cause more than economic loss for medical care. They also can cause considerable pain and suffering. You can receive money in a settlement to make up for this pain. Of course, no amount of money will ever get your old body back. Nevertheless, money is the best that the legal system can do, so you should receive some compensation for pain and suffering if you have suffered serious physical injuries.
The amount you will receive should depend on the severity of your injuries. If you feel discomfort for a few months, then you will receive less than if you are permanently in pain or are paralyzed. The amount you receive in a settlement will approximate the amount a jury would award you based on the evidence. Basically, jurors will use their life experience to come up with a number that seems fair.
Because pain and suffering damages arise out of your physical injuries, the IRS does not require that you pay taxes on this amount. So damages for pain and suffering are exempt just like compensation you received for medical bills.
Money Received for Property Damage
You also might have received compensation for damage to your vehicle or other property in a settlement. You should be pleased to know that this amount of money is also not taxable, whether the money went to the costs of repairs or to reimburse you for renting a vehicle after the crash. Again, these are out-of-pocket expenses that you are being reimbursed for, so it would be unfair to tax them as income.
Money Received for Lost Income
Many accidents leave our clients in considerable pain, and they often need to stay holed up at home or in the hospital for months at a time so they can heal. During this period, many of them cannot work, so they lose out on income. In a settlement or jury verdict, our clients can receive compensation to make up for this lost income.
When injuries are very serious, our clients have also received lost future income as well. For example, someone who is paralyzed from the waist down probably cannot return to her old job as a delivery driver. If she can qualify for other work, it might pay far less than her previous job, so she is losing out on money even if she returns to work. As a result, a client can receive compensation for this lost future income.
When it comes to taxes, however, you will have to report the compensation you receive for lost wages on your tax return. This isn't surprising. After all, your income would have been taxed had you been able to work. It is only fair that the compensation you receive to make up for lost wages is also taxed, so you will need to include it in your gross income at tax time.
Compensation for Emotional Distress
An accident is a shocking event. It can cause severe emotional distress in a victim, which can result in negative emotions such as:
In Connecticut, car crash victims can receive money for this emotional distress to help make up for it. In many settlements, our clients receive emotional distress damages, also called “mental anguish” damages.
The IRS position regarding compensation for emotional distress is tricky. As mentioned above, emotional distress damages are not excluded from income as a general rule. However, the amounts will be excluded if the emotional distress arises from physical injuries. Let's look at some examples.
Example A: While backing out of your driveway, you are struck by a driver, who slams into you and then rolls onto your front yard, where the driver strikes your child, severely injuring her. Seeing your child get hit is an emotionally traumatic experience, and you can receive compensation for it. However, because the damages in this example do not arise out of your physical injuries, you probably cannot exclude these damages from your income at tax time.
Example B: You are T-boned in an intersection and suffer devastating back injuries that leave you in constant pain whenever you breathe. As a result of these physical injuries, you slip into a deep funk and become depressed. Here, you can also receive compensation for emotional distress as part of your settlement. However, since your distress arises out of your physical injuries, you can exclude it from your income.
You might be confused about whether the emotional distress damages are compensating distress that arises out of your physical injuries, so contact a Connecticut auto accident lawyer for assistance.
Interest Earned on Your Settlement
Many settlements are quite large, and our clients end up depositing them in the bank, where they can earn interest. You typically will need to include any interest earned on your tax return. In fact, there are specific lines you will need to use to report those interest amounts. With the rate of return so low, you probably are not looking at a considerable amount of interest.
Some accident victims receive punitive damages as part of a settlement or jury award. Punitive damages (also called “exemplary damages”) are in a class of their own. They are designed to punish a defendant when his or her conduct is reprehensible, with the hopes of deterring any future bad conduct.
Punitive damages are rare in New Britain car accident cases, but some of our clients have been awarded them. Punitive damages are usually capped, so juries do not run wild and award too much. They are more likely in a jury verdict than in a settlement.
Unlike medical bills and pain and suffering, you must report your punitive damages on your tax return. Again, punitive damages do not compensate for your out-of-pocket losses, so it is fair to require that you pay tax on these amounts. You should include them on your tax return.
Find Your Settlement Agreement
Now that you understand how the IRS analyzes damages generally, you need to see how these rules apply to your situation. Your car accident settlement should have been memorialized in a settlement agreement, which contains very important information. Find your copy of this agreement and read it. If you do not have a copy handy, then contact your personal injury attorney, who should have a copy that you can review.
You might have gone to trial after settlement negotiations broke down. As part of its verdict, the jury should have broken out how much money it is awarding for compensatory reasons and how much (if any) it awarded for punitive damages. You should ask your lawyer for a copy of the jury verdict. Otherwise, you will need to get a copy from the court where your lawsuit was heard.
Analyze Your Settlement or Jury Verdict
As part of the settlement agreement, your lawyer should have classified your damages. For example, a hypothetical car accident settlement might have been for $100,000 and been divided this way:
- Medical bills: $20,000
- Lost wages: $15,000
- Property damage: $15,000
- Pain and suffering: $30,000
- Emotional distress: $20,000
You can now go through each damage amount and determine whether you must include it in your income tax return or whether you can exclude the amount:
- Medical bills: No, these amounts are excluded because they arise out of a physical injury. You won't pay taxes on this amount.
- Lost wages: Yes, you must pay taxes on this amount because it is not excluded from your gross income.
- Property damage: No, you don't have to pay income tax on this amount of compensation.
- Pain and suffering: Because it arises out of your physical injury, you do not need to pay income taxes on these damages.
- Emotional distress: If your emotional distress arises out of your physical injuries, then it is not taxable. However, if it does not arise out of physical injuries, you will need to include the amounts.
In this example, only $15,000 must be included on your income tax form and pay taxes on it. (We'll assume emotional distress damages are a result of your physical injuries). Since compensation for lost wages is considered income, you will be taxed at the same rate as all of your income. Of course, by including this amount, you might end up in a higher income bracket, but you would end up there anyway if you had not been injured but had continued to work.
Now imagine that you had received $130,000 because you receive an additional $30,000 in punitive damages. If so, then you will probably need to claim the $30,000 as punitive damages on your tax return as well. This means that you would end up claiming $45,000 as income–$30,000 for punitive damages and $15,000 for lost income.
Structuring a Settlement Properly
If you haven't yet agreed to a settlement and are only reading this article out of curiosity, then you hopefully realize how important it is to draft a settlement agreement properly. When people try to negotiate their own settlements and write up their own agreements, they often lump together all compensation—medical bills and lost wages get thrown together with emotional distress and pain and suffering damages. As a result, it is hard to untangle and prove how much of your compensation was received for reasons that won't be taxed—medical care, pain and suffering, etc.—and separate it from the amounts that will be taxed.
Remember, if the IRS challenges you, then you as the taxpayer have the burden of convincing them that the amount of money you received in a settlement is not for a taxable purpose. This can be difficult if you haven't kept accurate and timely records.
To protect yourself, you should work with an experienced Hartford County auto accident attorney when negotiating a settlement. At James F. Aspell, P.C. for example, we will create a settlement agreement that clearly and accurately classifies damages so there is no question what you are receiving compensation for and why. Our settlement agreements are a big help when it comes to tax season and you need proof that most of your settlement is tax-exempt.
Get Help from a Tax Attorney
This article is not a substitute for legal advice from a qualified tax attorney. Some injured victims have very complicated settlements. For example, some settlements are structured so that compensation is paid in installments that can stretch out over several years.
To properly understand what you need to claim and when, you should meet with an experienced tax attorney. If you need help finding one, ask the lawyer who represented you in your personal injury case for a referral. They often know of someone who can answer your questions.
Contact Us Today
At the Law offices of James F. Aspell, P.C. , we represent auto accident victims, and we fight to get them the compensation they need after a devastating auto accident. Our entire approach is designed to make you “whole,” so that you are not needlessly suffering financially after an accident that is not your fault. To this end, we will fight to maximize the amount that you can receive for pain and suffering, emotional distress, and other damages.
Contact us today. We are happy to work with motorists who have been injured in an accident but don't know how to begin the process of obtaining the compensation they need. This is a very confusing time, but after over 30 years, we have seen almost everything.
Having stood toe to toe with Connecticut's largest insurance companies, we have seen all the tricks and will not back down. For more information about how we can help you obtain a settlement, please contact us today. You can call or send us an online message. We are proud to offer a free case evaluation to those who call us or send us an online message.
You will pay nothing until we win your case, so there is no risk in talking with us.