Receiving a settlement check after a long, arduous personal injury case often feels like the final chapter of a difficult book. You’ve dealt with the accident, the recovery, the insurance adjusters, and the legal arguments. Finally, there is a resolution. But just as you prepare to deposit that check and move forward, a nagging question often arises: Does the IRS get a cut?
It is a valid concern. Most money that changes hands in the United States is subject to taxation, and the sums involved in injury settlements can be substantial. However, the tax code regarding legal settlements is nuanced. It isn’t as simple as declaring everything as income, nor is it a blanket exemption where you walk away tax-free. The reality lies somewhere in the middle, dependent entirely on why you were paid.
The fundamental principle the IRS uses to determine taxability is the “origin of the claim.” Essentially, what was the money meant to replace? If the money is meant to make you whole after a physical loss, the tax treatment is generally favorable. If it is meant to replace taxable income or punish the defendant, the taxman will likely want his share.
Physical Injury and Sickness
At the core of the tax code regarding settlements, specifically Section 104(a)(2) of the Internal Revenue Code, is the concept of “physical injury or physical sickness.”
If you receive a settlement (or a court verdict) compensating you for personal physical injuries or physical sickness, those proceeds are generally tax-free. The logic here is that this money isn’t “income” in the traditional sense of increasing your wealth. Instead, it is restoration. You lost health or physical capacity, and the money is an attempt to restore the value of what was lost.
This exclusion covers a wide umbrella of damages related to the injury. For instance, if you were in a car accident and suffered a broken leg, the portion of the settlement designated for your medical bills is not taxable. Similarly, pain and suffering damages that result directly from that physical injury are also excluded from gross income.
The Gray Area of Emotional Distress
This is where many plaintiffs find themselves confused. Emotional distress is a very real, very debilitating outcome of negligence. However, the IRS treats it differently depending on its root cause.
If your emotional distress stems directly from a physical injury; for example, you develop anxiety or PTSD after a severe dog bite; the compensation for that distress is treated the same as the physical injury: tax-free. The law views the mental anguish as a symptom of the bodily harm.
The situation flips if the claim is only for emotional distress. Consider a case of employment discrimination or defamation. You might suffer severe headaches, insomnia, or stomach issues due to stress. While these are physical symptoms, the IRS generally views the origin of the claim as non-physical. Therefore, settlement money for emotional distress in these non-physical cases is usually taxable.
There is a small caveat: even in non-physical cases, the portion of the settlement used specifically to pay for medical care to treat the emotional distress is not taxable. If you saw a psychiatrist or took medication, those specific reimbursed costs remain tax-free, provided you haven’t already deducted them on a prior tax return.
Lost Wages
One of the most common components of a personal injury claim is reimbursement for lost wages. If you couldn’t work for six months because of your injury, your settlement will likely include an amount equivalent to that lost salary.
Logic might suggest that since this stems from a physical injury, it should be tax-free. However, the IRS views this differently. If you had earned that money by working, you would have paid income tax on it. Therefore, if a settlement replaces that income, it remains taxable.
In practice, however, many settlements are paid out as a lump sum without a specific breakdown of what dollar amount is for pain and suffering versus lost wages. In these “general” settlements, the entire amount is often treated as being for the personal physical injury (and thus tax-free), unless the settlement agreement specifically allocates a portion to lost wages. This is why the specific wording of the release or settlement agreement is critical. A skilled attorney will often draft the agreement to maximize the tax-free portion of the recovery, provided the facts support it.
The Punitive Damages Trap
While compensatory damages are meant to make the victim whole, punitive damages serve a different purpose: to punish the defendant for particularly reckless or malicious behavior and deter them from doing it again.
Because punitive damages are not about restoration but rather retribution, the IRS considers them fully taxable income. It does not matter if the punitive damages arose from a horrific physical injury case; that specific portion of the money is always taxable.
This can create a complicated tax situation. If a jury awards you $1 million in compensatory damages and $2 million in punitive damages, you are looking at a significant tax bill on the $2 million. Furthermore, you may have to pay taxes on the full punitive amount even if your attorney takes a 33% fee from it. You are effectively taxed on money you never actually put in your pocket, although recent tax law changes have made deducting those legal fees more difficult for certain types of cases.
Interest on the Settlement
Legal battles move slowly. It is not uncommon for a case to drag on for years. In some jurisdictions, the court adds “pre-judgment interest” or “post-judgment interest” to the final award to compensate the plaintiff for the time value of money.
The IRS treats this interest just like interest from a bank account: it is taxable income. Even if the underlying settlement for physical injury is tax-free, the interest accrued on top of it is not. This often surprises clients who assume the “tax-free” label applies to the entire check.
Structuring the Settlement
For large settlements, how the money is paid out can also impact your financial planning, if not the taxability itself. Some plaintiffs opt for a “structured settlement,” where the money is paid out over time through an annuity rather than in a single lump sum.
If the underlying damages are for physical injury, the payments from a structured settlement remain tax-free, including the growth portion of the annuity. This can be a powerful financial tool, ensuring long-term income without the tax burden that would come from investing a lump sum in the stock market (where gains would be taxed).
Protect Your Rights and Your Recovery
Don’t leave your financial future to chance. If you have been injured and need guidance on your claim, reach out to our experienced team at Marc S. Albert today. We have convenient locations across New York to serve you.
You can visit us at:
- Astoria – 32-72 Steinway St, Astoria, NY 11103
- Brooklyn – 7113 5th Avenue, Brooklyn, NY 11209
- Syosset – 175 Jericho Turnpike, Syosset, NY 11791
Or call now for a free consultation on (347) 472-5080.