When you're involved in a personal injury lawsuit, the legal process can sometimes feel overwhelming and complicated. Negotiating with an insurance company for fair compensation can take anywhere from weeks to months or even years. Receiving financial compensation is an exciting moment, however, it's important to look beyond just the amount being offered and into the way the settlement is structured.
Before you sign any settlement offers, make sure you understand the structure of the settlement and identify any portions that may be taxable. When certain types of awards are included in the offer, such as punitive damages, a poorly structured settlement can increase your tax liability and end up costing you thousands.
It is always in your best interest to get legal advice before you accept a settlement. Speaking with an attorney about an offer can help you maximize your legal benefit and eliminate any unnecessary tax liability. Knowing the most common types of compensation awarded in personal injury lawsuits and how settlements are taxed, will help you understand if which portion, if any, of your personal injury settlement, is taxable.
When an acceptable settlement offer or verdict has been reached, either by way of a jury trial or settlement with the defendant, many individuals question if their personal injury settlement is taxable, or more specifically if compensatory damages or punitive damages are taxable. The easy answer to these questions is one you hear often in response to legal questions: It all depends. In this case, it depends on a lot of things, particularly the type of injury, the type of damages you are being compensated for, or the reason for the compensation.
Compensation for a Physical Injury or Illness is Tax-free
Compensatory damages are just what they sound like. Their purpose is to try and make the injured person whole. They compensate the plaintiff for medical expenses, lost wages, emotional distress, and pain and suffering. These are generally not taxed by either the Internal Revenue Service (IRS) or New York State law, each of which has the same requirements and exceptions to their rules which are as follows.
Physical Injury or Physical Sickness
The physical injury is self-explanatory and involves damage to a body part. A physical sickness is when one person’s negligence causes another person to acquire a physical illness. One example of an illness caused by negligence is mesothelioma, which is a type of lung cancer caused only by exposure to asbestos.
According to New York law,1 “the settlement amount received is primarily to pay for damages that occurred to a person’s body because of another person’s negligence.” When a physical injury or illness causes the person to experience pain, suffering, and emotional stress, these injuries are related to physical illness or injury, so they are not taxable.
Emotional Distress and Mental Anguish
Damages for pain and suffering and emotional distress that were caused by, or the result of, a physical injury or illness will not be taxed. When the basis for a lawsuit is that the injury was emotional distress, and no physical injury or illness was involved, the compensatory damages will likely be taxed by both the IRS and New York state law.
For example, if the basis for a personal injury lawsuit is a claim that a business suffered a loss and the owner’s reputation was damaged due to a false rumor passed around negligently or intentionally, and as a result, the owner suffered emotional distress and mental anguish, the award will be taxable. There was no related physical injury or illness, only emotional distress.
There may be an exception to the exception. If the award includes an amount to reimburse the person with emotional distress or mental anguish for out-of-pocket costs used to treat the distress, that amount is likely not taxable.
Injury or Illness Related Loss of Wages or Loss of Income
If lost wages are part of the award or settlement for the physical injury or sickness, they are considered part of the compensatory damages and are not taxed in the State of New York.
Punitive Damages and Taxable Exceptions
Punitive damages are damages designed to punish a defendant and may be imposed when a judge or jury finds the conduct of the defendant was particularly egregious. While these types of damages are not very common in personal injury lawsuits, it is important to understand the tax implications of an award that may include punitive damages. Are punitive damages taxable in New York? Yes.
Recently, in a class action case involving 22 women who claimed they contracted ovarian cancer as a result of using baby powder made by Johnson & Johnson, the jury awarded the plaintiffs $550 million in compensatory damages and $4.14 billion in punitive damages. They found the company finding the company acted egregiously in selling the powder without warning of the risks users of the product faced.
Since compensatory damages are tax-free, and punitive damages are taxable, the award needed to be structured very carefully to distinguish which amount was awarded for each classification of damage. Ensuring a settlement clearly identifies the amount awarded to both compensatory and punitive damages separately is critical to understanding your tax liability.
Previously Deducted Out-of-pocket Medical Expenses
If an injured person deducted their medical expenses from their tax return one year and then is reimbursed for those same medical expenses in a subsequent year, the amount that was deducted in a previous year must be declared as income in the year it was received.
Loss of Wages or Loss of Income From Employment-related Lawsuits
If lost wages are part of the award or settlement for the physical injury or sickness, they are part of the compensatory damages and are not taxed. On the other hand, if the lost wages are the result of an employment-related lawsuit, such as for discrimination or wrongful termination, the loss of wages is taxable. This is because the lost wages or income would have been taxed if earned, so damages awarded for those losses are also taxable by both the IRS and New York State.
Interest on the Judgment
There are times when the award after the trial or in a settlement includes interest that accumulated between the time of the injury or sickness and the time plaintiffs actually collect their compensation. The amount of the interest is taxable by both the IRS and New York State.
How an Attorney Can Help
It is always in your best interest to get legal advice before you accept any settlement offers. An experienced attorney can help you understand the differences between the types of damages you are being offered and will make sure to know the tax liabilities associated with each type. In certain cases, a poorly structured settlement can cost you thousands of dollars in tax liability. Furthermore, failing to include any taxable portions of your award in your yearly taxes can cause headaches with the IRS.
If you have questions on personal injury settlements tax liability, or if compensatory or punitive damages are taxable, Raphaelson & Levine Law Firm can help. To speak with one of our knowledgeable attorneys, call 212-268-3222 or complete the contact form below. We offer a free consultation where we will answer any questions you may have about filing a personal injury claim or the tax implications associated with a successful settlement or jury award.
Sources:
1 http://www.nystax.net/insurance-settlements-tax.htm
2 https://www.irs.gov/pub/irs-pdf/p4345.pdf
