One of the common concerns our clients have is that they will end up losing a large part of their personal injury settlement to income taxes. One of the happiest moments is when they first learn that that’s not true. Most personal injury recoveries are not subject to income taxes. The Internal Revenue Service considers that money received because of a personal injury is a replacement for something that has been lost, and so does not count as income. If you find that hard to believe, you can read about it here. Many states, including Massachusetts, follow the same rule.
Compensation for a physical injury, whether it results from a settlement or a jury award, and whether it is paid as a lump sum or as a structured payout, is simply not considered income. This can make structured settlements advantageous in some cases. The easiest way to remember this principle is that the money is not taxed when it first comes into the victim’s hands, whether as a lump sum or an annuity payment. Once the money is received, future investment income from that money is treated the same way as any other investment.
However, there are some exceptions for other types of tort settlements. If the injury is strictly emotional and not physical, the monies are generally taxable income. Likewise, the proceeds of an employment discrimination case, where compensation is received for lost wages, are considered income. If an award includes interest, the amount of interest must be reported as income, because the money it replaces (the amount that might have been earned on the compensatory damages) would have been taxable. And punitive damages are also taxable, because they are intended to punish a wrongdoer, rather than as direct compensation for a loss to the victim.
The taxation of recoveries for wrongful death cases is more complicated and depends upon state law and the allocation of the settlement proceeds among different claims. Some states provide that some or all of the recovery goes directly to beneficiaries or family members, without ever passing through the decedent’s estate, and thus these amounts are not subject to income or estate taxation. Other portions of the recovery, usually for conscious pain and suffering or for the decedent’s own losses (where permitted by law) become assets of the estate and may be taxed where the size of the estate is such that it is subject to tax.
Lawyers and clients should take these general rules into account when negotiating settlements. However, it’s also important that clients consult with their own accountant or tax professionals, to make sure that there is nothing about their individual situations or cases that would create an exception to these general principles. It’s also important to remember that different rules may apply to family law issues such as alimony or child support issues–so just because the IRS doesn’t consider a settlement taxable income doesn’t mean that its receipt can be completely ignored.