Taxes on Personal Injury Awards and Settlements

Hopefully, you will never need to know how payments for personal injuries are taxed. But here are the rules, just in case you or a loved one need to understand the rules. Payments for Physical Injury or Sickness Are Federal-Income-Tax-Free

Payments you receive as compensation for physical injury or physical sickness are federal-income-tax-free (Internal Revenue Code Section 104(a)(2)). It does not matter if the compensation is from a court-ordered award or an out-of-court settlement, and it makes no difference if it is paid in a lump sum or installments. Compensation for emotional distress that arises from physical injury or sickness is also tax-free, because the distress is considered part and parcel of the physical injury or sickness (Proposed Treasury Regulation 1.104-1(c)).

Amounts received for medical expenses are tax-free, too. However, if you claim a medical expense deduction for costs that are 

later reimbursed by an award or settlement, you must “recapture” any amount that is specifically allocated to medical cost reimbursements up to the amount you’ve previously deducted on your tax returns. When there is no specific allocation to previously deducted medical expenses, the award or settlement is automatically considered to be a reimbursement for such expenses up to the amount of those expenses (IRS Revenue Ruling 75-230).

If any part of your award or settlement is deemed to be interest for the period between the physical injury or sickness and the time you get paid, that part is taxable. (This “origin of the claim” doctrine was decided in the key court case of Rosemary Kovacs, 100 TC 124, 1993, which was affirmed by the Sixth Circuit Court of Appeals in 1994.) 

Oddly enough, amounts paid for lost wages are federal-income-tax-free, even though the wages would have been taxable if you had received them.

Example: Let’s say you were seriously injured in a 2009 auto accident. You racked up $65,000 in medical expenses and $80,000 in lost wages. On your 2009 and 2010 returns, you claimed medical expense deductions totaling $40,000. (You couldn’t deduct the full $65,000 because of tax-law limitations on medical write-offs.) You eventually receive a $650,000 out-of-court settlement that covers medical expenses, lost wages, pain and suffering, and $50,000 for interest. Only $90,000 is taxable ($40,000 for the medical expenses that were previously deducted and then reimbursed and the $50,000 for interest). The remaining $560,000 ($650,000 minus $40,000 minus $50,000) is free from federal income tax.

Other Payments Are Generally Taxable

Payments for legal (as opposed to physical) injuries from things like harassment, discrimination, wrongful termination, libel, and invasion of privacy are taxable. The same is true for payments for emotional distress that is not caused by physical injury or sickness. Related payments for interest are also taxable.

As a general rule, payments for punitive damages (amounts paid for the specific purpose of punishing the wrongdoer) are taxable even if they are paid as compensation for physical injury or sickness (Internal Revenue Code Section 104(a)(2)).

There is one exception to this general rule. Federal-income-tax-free treatment applies to punitive damages paid in civil wrongful death actions when applicable state law, in effect on September 13, 1995, allows only punitive damages in such cases (Internal Revenue Code Section 104(c)). Interest payments related to punitive damages (whether taxable or tax-free) are taxable.

What about Attorneys’ Fees?

You cannot deduct attorneys’ fees incurred to collect a tax-free award or settlement for physical injury or sickness. In other words, no deductions are allowed for fees to collect tax-free compensation (Internal Revenue Code Section 265 and Treasury Regulation 1.265-1(a)).

After that, the rules change and are not so favorable. Let’s say part of your award or settlement is tax-free (for physical injury or sickness), and part is taxable (for interest or punitive damages). As a general rule, you must report the full amount of the taxable portion of the award or settlement as income on your return, without any reduction for the related attorneys’ fees. Then, you can treat the fees related to the taxable portion as a miscellaneous itemized deduction item on Schedule A of your Form 1040. Calculate the deduction by multiplying the total fees by a fraction. The numerator is the taxable portion of your award or settlement, and the denominator is the total amount of the award or settlement.

Unfortunately, there are harsh limitations on miscellaneous itemized deductions. You can write them off only to the extent they exceed 2 percent of your adjusted gross income. In addition, they are completely disallowed for alternative minimum tax purposes. Therefore, your actual write-off for legal fees may be reduced to little or nothing (Internal Revenue Code Sections 212, 67(b), and 56(b)(1)(A)(i)).

In this unfortunate scenario, you could potentially wind up with only a small fraction of your award or settlement after paying your attorney and the IRS.

Special Rule for Attorneys’ Fees in Discrimination Cases

There is one big exception to the preceding unfavorable general rule for attorneys’ fees. Fees incurred in certain unlawful discrimination cases can be deducted in full on page 1 of your Form 1040 without any limitations (Internal Revenue Code Section 62(a)(20)). That way, you are not taxed on this money because you can deduct the amount.

For purposes of this beneficial exception, unlawful discrimination is defined as violating any one of a whole list of laws that mostly have to do with civil rights, labor and employment rights, housing rights, disability rights, and whistleblower rights (Internal Revenue Code Section 62(e)). If your case does not involve violating one of these laws, your attorney’s fees fall under the unfavorable general rule. (Miscellaneous itemized deduction treatment applies and your actual write-off may be little or nothing.)

Remember: The issue of deducting attorneys’ fees arises only in the context of an award or settlement that is at least partially taxable. Fees related to tax-free compensation for physical injury or sickness are always nondeductible.