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Tax Implications of Personal Injury Settlement Funds
When you are dealing with a personal injury claim, it’s natural to be concerned about when and how much you might get paid. Whether you’ve been in a car accident or have suffered injuries due to premises liability, you might be facing large medical bills, loss of income due to being unable to work, and other challenges. Knowing that settlement funds are coming your way can provide a lot of peace of mind.
But how much of those settlement funds will you get to keep? Many people don’t realize that some settlement funds have to be included as taxable income when filing a tax return the year after the funds were received.
Do You Pay Federal Income Taxes on Lawsuit Settlements?
According to the Internal Revenue Service, settlement funds must be included in federal income for tax filing purposes unless they are specifically exempted by the tax code. The good news is that any damages you receive based on physical injuries are exempted and don’t have to be included as taxable income.
The law goes further to define the exemption as any damages except for punitive damages that are received based on losses associated with physical sickness or personal injury. That’s true whether you get a lump sum or periodic payments based on a settlement or win an award in court.
If you are awarded punitive damages, you have to report the amount as income to the IRS and may be taxed on those funds. Punitive damages are not related to specific economic losses. They are awarded as a way to “punish” the defendant. Punitive damages are rare compared to other types of compensation, and courts use this option to make a statement if a defendant is deemed to have acted with extreme gross negligence. Ultimately, the goal is to keep the defendant from repeating the actions and keep other people from acting in the same way.
Does California Tax Your Personal Injury Settlement?
Of course, when you file your income tax return each year, you also have to file a state income tax form. California has similar rules to the IRS when it comes to taxation on settlements. The compensation you receive that is directly related to your physical injury is not typically taxable in the state. Even settlements related to emotional distress may not be taxable if the emotional distress is related to a physical injury.
However, if punitive damages are awarded, those are taxable in California.
The Details Matter
It’s important to note that specific details can determine whether part of your settlement is taxable or not. For example, consider a situation where someone is injured and begins to incur medical expenses prior to any settlement. They pay some of those medical expenses and itemize their tax return, claiming a deduction for the medical expenses.
That person has already received the tax break for the medical expenses. If they are awarded compensation for those same expenses, they may have to claim that new income. Otherwise, they double up on the tax break.
What Other Fees and Payments Come Out of Your Settlement Amount?
Taxes aren’t the only thing that can reduce the amount of your settlement. You will likely need to pay your attorney, for example. Many personal injury attorneys work on a contingency basis. This means they take their pay out of your settlement.
In California, an estimated average contingency fee is 33% of the settlement amount—though the amount can be more or less. Depending on how an attorney structures their fees, you may need to pay a contingency fee plus expenses related to filing and court fees, copy costs, or other direct expenses.
In some cases, there may also be a medical or insurance lien against your settlement. This can occur in a few situations. The first is if you don’t pay your medical bills. The provider has a right to their part of your compensation if you were reimbursed for those medical costs. The second is if your insurance company covered some costs for medical care. In some cases, the insurance company may not ultimately be the correct payer if another party is liable. If you are reimbursed for costs that your insurance company covered, it has a claim on that portion of the settlement.
Talk to Your Attorney About Settlement Considerations
As you can see, lawsuit settlement funds can be complex. While it’s exciting to learn that your case has been settled and to know that money is on its way to you, it’s important to keep realistic timelines in mind. It can take several weeks or more to sort out all the details related to the settlement before you receive your portion of the payment.
Once you do receive your settlement funds, you may want to work with a tax or accounting professional to ensure you appropriately report income on your tax return while also seeking to minimize any tax burden.
If you are dealing with a personal injury issue and want to find out if you have a case for compensation, we can help. Our team can review your case and let you know whether you have a viable potential claim and how to proceed with it. For more information or to work with the Weinberger Law Firm, call 916-520-0476 today.
