If you’ve been injured in an accident that wasn’t your fault, you may be entitled to compensation. A settlement or court judgment can be sizable — even life-changing — covering your past and future medical expenses, lost wages, and property damage, and compensating you for your pain and suffering, mental anguish, and your injury’s long-term impact on your quality of life.
But do you have to pay taxes on your settlement? This is a common concern for many of our clients, and it’s a vital question to consider if you’re considering pursuing a claim.
After all, navigating the legal process of pursuing compensation while you’re trying to focus on your recovery can be stressful. Insurance adjusters might hound you for updates on your injuries or a statement about what happened. Your employer might pressure you to return to work — and you might be tempted if you have a family to provide for. You’re justified in wondering, “Is it all worth it?”
In this blog post, we break down what goes into calculating a settlement and the various factors that affect how much you receive, how personal injury settlement tax works, whether settlements and judgments obtained via a lawsuit are taxed differently, and what steps to take to maximize your compensation while complying with tax laws.
Understanding Personal Injury Settlements
When you’re injured because of someone else’s negligence — whether in a car accident, slip and fall, or any other incident — you could recover compensation for your injuries and related expenses. This compensation often comes as a settlement, where the at-fault party (or their insurance company) agrees to pay you a sum to resolve your claim. Accepting a settlement prevents you from pursuing legal action later.
A typical personal injury settlement might include compensation for:
- Medical expenses
- Lost wages
- Pain and suffering
- Property damage
- Future medical costs
- Loss of earning capacity.
If negotiations fail, you can file a lawsuit, which begins the personal injury court procedure. During this process, both parties will engage in discovery (gathering evidence) and proceed toward trial. During a trial, a jury will hear evidence from the plaintiff (the injured party) and the defendant (the at-fault party defending the claim), and determine if the defendant is liable. If the jury finds fault, they can award compensation for the damages mentioned above. They can also award punitive damages if they find a defendant’s conduct especially egregious.
However, settlement negotiations continue throughout the pre-trial process, and you may reach an agreement before you get a court date.
Book a free case review with our Texas personal injury attorney today to find out how much compensation you could recover and whether you’ll need to pay tax on your recovery. You don’t pay fees until we win your case.
Do You Have to Pay Taxes on Your Settlement?
According to the Internal Revenue Service (IRS), all income is taxable. But does personal injury compensation count as income? Generally, the answer is no. Personal injury settlements are not considered income, so you do not have to report your compensation on your tax return.
This rule applies to lump-sum settlements (paid in one go) and structured settlements (payments over time). The reason for a lack of personal injury settlement tax lies in the purpose of compensation — it is meant to make you “whole” again after your injury and compensate you for your losses, not provide you with additional income.
However, as with many aspects of tax law, there are some exceptions and nuances to be aware of.
Breaking Down the Internal Revenue Code
The Internal Revenue Code (IRC) contains the federal tax laws in the United States. Several sections pertain specifically to personal injury settlement tax:
- IRC Section 61 explains that any amount earned is included in gross income unless a specific exception exists.
- IRC Section 104 states that gross income does not include damages received on account of personal physical injuries. It further clarifies that taxpayers can exclude from gross income “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or physical sickness.”
Understanding the Exceptions: When Parts of Your Settlement May Be Taxable
So what does this actually mean? What are physical injuries, and does this mean you have to pay taxes on a settlement when you receive damages for non-physical injuries, such as emotional distress?
Non-Physical Injuries
The Internal Revenue Code explains that gross income does not include damages recovered for physical injuries, meaning this income is not taxed. However, damages for emotional distress and mental anguish are treated a little differently.
Mental and emotional distress arising from non-physical injuries are only excludable from gross income if they result from physical injury or sickness.
Let’s look at an example.
A person is driving when a speeding car comes hurtling toward them. The driver sees the car on time, swerves, and avoids a direct collision. They are not physically hurt and their car is not damaged. However, after the crash, the driver who avoided the collision experiences debilitating anxiety. They are terrified of getting back behind the wheel or even being on the road, fearing another accident might happen and they might not be so lucky next time. Their driving anxiety becomes so severe that it affects their work — they are constantly late and distracted. They refuse to leave the house, relying on family members to run errands and drive their children to school. They become increasingly fearful and withdrawn, resulting in depression and emotional outbursts.
If this person received compensation from the speeding driver’s insurer for their emotional distress, it would be taxable, as their driving anxiety did not stem from a physical injury.
To make matters more complicated, the IRS acknowledges that accident victims might experience physical symptoms resulting from emotional distress, such as headaches and stomachaches. However, if the emotional distress causes you to become physically sick, any recovery or settlement will still be taxed.
This wasn’t always the case. Before 1996, IRC Section 104 did not refer explicitly to “physical” injuries. Today, however, emotional distress must result from a physical injury for compensation to be tax-free.
Emotional distress isn’t the only exception resulting in paying tax on your personal injury compensation.
Punitive Damages
If your settlement includes punitive damages — which are intended to punish the defendant for particularly egregious behavior rather than compensate you for your losses — these are also taxable. It’s worth noting that punitive damages are relatively rare in personal injury cases in Texas.
Punitive damages are awardable by a jury, so you must file a lawsuit and take your case to trial to be eligible.
Most cases settle long before this stage, either via a settlement before filing a lawsuit, or during ongoing negotiations during the pre-trial phase. Going to court is a risk for both parties; a jury may decide the defendant was not negligent and did not cause your injuries, meaning you would not receive compensation. Alternatively, a jury might determine the defendant was grossly negligent and award a judgment far exceeding any offer made during negotiations. Therefore, it can be in the best interests of both parties to agree to resolve a case out of court. A defendant might also prefer to settle to avoid public scrutiny and potential reputation damage, as a settlement can be kept confidential.
Accrued Interest
Personal injury claims can take substantial time to resolve. Most courts award interest on compensation, accrued from when a lawsuit is filed until the defendant pays in full. If a verdict is appealed and must go through the appellate process, the amount of interest adds up. While this interest adds value to your case, accrued interest must be reported as income as it is taxable.
How to Minimize the Tax Impact of Your Settlement
It’s vital to understand whether you’re required to pay settlement tax to avoid being caught short and facing a substantial bill. But what steps should you take to minimize the impact of your recovery on your taxes?
1. Work with Your Attorney
A personal injury attorney can explain the tax implications of your settlement and allocate funds accordingly. Every claim is unique and — as we’ve highlighted — some damages may be taxable while others are not. Our San Antonio and McAllen personal injury lawyer can separate your awards, giving you a stronger chance of holding onto your rightful compensation if the IRS challenges your settlement or verdict.
2. Consider a Structured Settlement
For larger settlements, a structured settlement may be more manageable for tax purposes than a lump sum. However, when considering a structured settlement, it’s vital to consult an attorney to determine how accrued interest might affect your tax liability, along with whether a set of smaller payouts will allow you to afford the ongoing treatment you need for your injuries.
5. Consult a Tax Professional
Tax law is complex, and the rules surrounding personal injury settlements can be nuanced. It’s always wise to speak to a professional who can provide advice tailored to your situation. You may also want to consult an accounting professional who can help you manage your settlement by setting aside a portion for any tax you are liable to pay and ensuring your compensation covers the future costs you have yet to incur for ongoing treatment or time off work.
Areas in Greater San Antonio We Serve
The Importance of Hiring a Personal Injury Attorney
An unexpected tax bill can have long-term consequences on your financial stability and compensation payout. The right personal injury attorney will use this knowledge to inform their strategy.
For example, if a defendant’s conduct was grossly negligent — such as if they were drunk driving — punitive damages may be on the table. When building their case and presenting their argument to the court, your attorney may push for a larger compensatory award to offset the tax obligations accompanying punitive damages.
But if your compensation is likely to be taxed and you want to keep as much compensation as possible, you may wonder if you need an attorney to negotiate a settlement or represent you in court.
Shortly after your accident, an insurance adjuster appointed to your claim — and representing the insurance company providing cover to the person or party that caused your injuries — will reach out to get your version of events and determine liability. If they are on the hook for paying you compensation, they will likely make you an offer to resolve your claim now. You might be tempted by this — you receive a compensation award and do not have to pay attorney fees.
However, taxes or not, it’s rarely advised to accept an early offer, as it’s unlikely to represent the damages you’re entitled to. If you don’t know how severe your injuries are, how much additional treatment you’ll need, or when you’ll be well enough to return to work, your compensation may not cover your long-term expenses. If your injuries later worsen or your recovery isn’t as smooth as you hoped, you may need further surgery or rehabilitation and be unable to afford it.
A personal injury attorney can assess the fairness of offers you receive and negotiate an appropriate settlement.
If you sue, a Texas personal injury lawyer can build a strong case and ensure you argue for all the damages you’re entitled to. They’ll also draw on their network of experts who can testify about the long-term impact of your injury on your life, how long you will continue to suffer, and prove the defendant is liable and that the accident was not your fault.
As a result, an attorney can often achieve a much larger recovery than if you go it alone. If any portion of your settlement or judgment is taxed, the larger value may lead to a higher tax bill, but this is typically offset by your bigger payout, resulting in you holding onto more compensation even after taxes and attorney fees.
Dealing with the aftermath of an injury is challenging enough without worrying about potential tax implications. For the most part, you won’t have to worry about paying tax on your personal injury settlement, but it’s crucial to know the exceptions in case they apply to you.
We’re committed to helping our clients navigate every aspect of their personal injury claims, including understanding the potential tax implications of their settlements. We work closely with our clients and, when necessary, tax professionals to protect our clients’ rights and maximize their compensation.
If you’ve been injured because of someone else’s negligence and are considering pursuing a personal injury claim, our award-winning personal injury lawyer can guide you through the process, explain your rights, and fight to secure the compensation you deserve.
Contact Patino Law Firm today for a free, no-obligation case review. Our personal injury attorney in San Antonio and McAllen can help you get the compensation you deserve and maximize your recovery. Se habla Español, and you won’t pay fees until we win.
