Many clients are surprised to learn that they must pay more than just attorney’s fees from a personal injury settlement. All law firms are required to charge for advanced costs and other expenses. In addition, health insurance plans, a law known as ERISA and other rules require personal injury victims to reimburse lots of medical expenses. After all of these deductions, many clients rightly ask whether taxing authorities will also get a piece of their settlement.
Thankfully, most personal injury settlements are exempt from taxation. The general rule is that such settlements are generally viewed as “compensation” and not “income” for taxation purposes. The legal theory is that personal injury settlements are designed to replace losses and are not intended to serve as income. This is good news because many payments for benefits which you might not think about are considered income for tax purposes. For example, lottery winnings, interest income, tips and even forgiven debts may be taxed under the IRS Code. Under current IRS regulations, however, most personal injury settlements remain exempt. Injury victims receiving compensation should, however, be somewhat cautious. First, not all damages are exempt. For example, punitive damages may still be subject to taxation. In addition, in other cases the IRS has considered whether recovered lost wages should be subject to taxation at the time of settlement. Finally, according to all authorities, interest income and dividends earned on all settlement proceeds are always taxable. The tax treatment of settlements can be especially important in larger settlements where a large lump sum can generate tens of thousands of dollars with income every year. Where this occurs, personal injury counsel must consider whether to employ a structured settlement, trust, or other device to minimize tax consequences.
Finally, nothing in this blog is intended to or can ever substitute for individualized tax advice. The structure of personal injury settlements and what to do with them after closing is a complicated topic and one which our firm tackles on a case by case basis with the assistance of accountants and other financial advisors. With the right input and proper advice, however, your personal injury settlement could be largely exempt from taxation (making it one of the last tax exempt payments around by our calculations).