American citizens can earn money in countless ways – only to discover they owe taxes on the income. Certain portions of a personal injury settlement may need to go to the Internal Revenue Service (IRS). Failing to pay required taxes can lead to fines and other legal penalties later. It’s important to clear up your tax obligations as soon as possible after receiving a settlement or case award.
Which Types of Compensation Require Tax Payments?
As a general rule, the money a plaintiff receives from a lawsuit for his or her physical injuries is nontaxable. This means a plaintiff’s compensation for medical expenses, lost income, pain and suffering, loss of consortium, and legal fees in a personal injury case count as nontaxable income.
It’s important to note that the type of injury a plaintiff incurred is a major distinction when determining tax obligations. Compensation for physical injuries and illnesses is nontaxable. A settlement or award that is only for emotional distress or employment discrimination is not. A lawsuit arising from breach of contract would also be exempt from the usual rule for physical injury compensation. The plaintiff would owe taxes on a settlement or case award for a successful breach of contract lawsuit.
Some lawsuits can last for months or even years, and some medical expenses are tax-deductible. If a plaintiff claimed medical expenses the prior year as tax deductions and those same expenses come into play during a lawsuit for the plaintiff’s injuries, the plaintiff may need to allocate a portion of the case award on a pro rata basis and claim the compensation as Other Income.
Compensation for lost wages or lost profits for business-based lawsuits may qualify as taxable income as well. For example, if a plaintiff wins an employment discrimination lawsuit and secures compensation for lost wages, the recovered earnings would still qualify for taxation under the usual tax laws that would have applied to those wages normally. The same applies for business-related losses. Losses that go toward the continuation of the business and the business owner would owe self-employment taxes on that compensation.
Punitive Damages and Interest
Punitive damages are always taxable income for a plaintiff. The amount a plaintiff will owe in taxes from punitive damages varies from state to state. The amount of punitive damages received will differ as well. Interest on compensation is also taxable. For example, if a plaintiff filed a lawsuit on December 31, 2016 and won at trial on December 31, 2017, the plaintiff would earn one year’s worth of taxable interest. If the defendant appealed the verdict and didn’t end up paying the plaintiff for another year, the plaintiff would earn two years’ worth of taxable interest income.
Maximizing Recovery After an Accident
It’s important for any plaintiff in a personal injury case to know the various ways of maximizing the compensation available from these lawsuits. For example, a plaintiff may have two separate claims against the same defendant. Some types of compensation in these claims may be taxable, so hiring a reliable Kansas City injury attorney is essential for navigating complex tax-related issues. In some cases, a plaintiff may need to clearly indicate which types of damages fall under which claim for tax purposes. This being said, ultimately nothing stopping the IRS from challenging a plaintiff’s declaration of taxable income from a lawsuit.
Hiring the right attorney can help plaintiffs meet their tax requirements while maximizing recovery. Additionally, a good attorney can help a client receive more nontaxable compensation than taxable compensation. Doing so can effectively reduce the client’s tax burden.