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 does need to understand the rules.
Physical Injury or Sickness Payments Are Federal-Income-Tax-Free
Payments you receive as compensation for physical injury or physical sickness are federal-income-tax-free. 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.
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.
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 6th 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 2016 auto accident. You racked up $65,000 in medical expenses and $80,000 in lost wages. On your 2016 and 2017 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.
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, only allows punitive damages in such cases. Interest payments related to punitive damages (whether taxable or tax-free) are taxable.
What about Attorney Fees?
You cannot deduct attorney 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.
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 attorney 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 only write them off to the extent they exceed 2% 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.
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 Attorney Fees in Discrimination Cases
There is one big exception to the preceding unfavorable general rule for attorney fees. Fees incurred in certain unlawful discrimination cases can be deducted in full on page 1 of your Form 1040 without any limitations. 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. 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 attorney fees only arises 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 non-deductible.
From the IRS
The IRS provides its auditors with a guide explaining the taxability of different types of awards and settlements. Here are some excerpts.
Wrongful Death: “Claims for wrongful death usually encompass compensatory damages for physical and mental injury, as well as punitive damages for reckless, malicious, or reprehensible conduct. As a result, both claims may generate settlement amounts. Any amounts determined to be compensatory for the personal injuries are excludable from gross income. … The amounts determined to be non-compensatory, that is, punitive payments, are not excludable.”
Libel and Defamation of Character: “Because damage to reputation, be it personal or business, is a nonphysical injury, only out-of-pocket costs to treat emotional distress can be excluded. Any other compensatory and punitive damages arising from these cases are taxable.”
Other Non-Physical Personal Injury: Lawsuits for negligence, fraud, breach of contract, etc., can include a variety of claims, and therefore can produce a variety of types of awards/settlements. Under current tax law, “only out-of-pocket amounts for medical costs incurred to treat any emotional distress claims would be excludable from income. All amounts determined to represent punitive damages are taxable.”
Back Pay Settlement after Termination: Let’s say an employee is illegally fired under a worker’s right or civil rights law. As part of a settlement, he or she receives back pay relating to a period when no services for the employer were performed because of the termination. The IRS states the back pay is considered “wages subject to employment taxes in the year paid, and subject to the tax rates and FICA and FUTA wage bases in effect in the year paid”
— Source: IRS Market Segment Specialization Program Publication Lawsuit Awards and Settlements
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