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Do you have to pay taxes on your personal injury settlement? Understanding the new tax law

Posted by Brian C. Zuanich | Mar 12, 2019 | 0 Comments

Congratulations, you've settled your personal injury case. But here comes the IRS.

Uncle Sam wants his cut.

No one enjoys tax season, except accountants and maybe tax lawyers. Just ask rapper and producer Dr. Dre:

“The only two things that scare me are God and the IRS.”

The Tax Cuts and Jobs Act of 2017

We're right in the middle of the 2018 tax season. But for many people, 2018 may be more stressful than most because we're living a new tax world. In December 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), the most sweeping reform of the U.S. tax code in over 35 years.

To some extent, the TCJA (aka the Trump Tax law) helps everyone. Many Americans are going to get a small tax break, and corporations and small businesses are going to get a big tax break.

But for personal injury plaintiffs, the TCJA could be bad news.   

So now is a perfect time to discuss the main tax rules that apply if you settle your personal injury case in the Trump tax era. 

Personal Physical Injury Damages Are Tax Free

We'll start with the good news.

Under the federal tax code (Section 104 to be exact), you don't pay taxes for damages you receive from “personal physical injuries." Most personal injury cases involve physical injuries—car accidents, defective products, slip and fall cases.

Let's use a simple car accident example to illustrate. Suppose Jane and John get into a car accident. Jane injures her back. She goes to the emergency room. The ER doctor prescribes pain medication and tells her to take it easy. Jane has some follow-up appointments with her primary care doctor. She misses a week of work. 

Jane eventually settles her claim with John's insurance company for $100,000. Because Jane's settlement is directly related to her back injury, Jane gets this money tax-free. In fact, she does not have to report any of it to the IRS—that's right, not one single cent.

In a physical injury case, it doesn't matter what type of damages you receive. Pain and suffering, property damage, medical expenses, lost and future wages, loss of earning capacity—all kinds of “compensatory damages” are tax-free. It doesn't matter whether you receive a lump sum settlement or you're paid in installments. And it doesn't matter whether you settle your case before filing a lawsuit, during litigation, or winning your case in front of a jury.

Non-Physical Injury Damages Are Taxable

Non-physical personal injury damages are a different story. You are legally required to report this income to the IRS and pay taxes on it. Suppose Jane settles her car accident case, but later sues her attorney for legal practice, claiming she received bad settlement advice. If she wins her malpractice claim, her damages are taxable. 

Wait, you might say. Doesn't Jane's malpractice claim relate to her car accident? Yes, in a broad sense, but her physical injuries didn't produceher malpractice claim. Instead, her malpractice claim flowed directly from her attorney's poor performance.  

Emotional Damages Are Taxable

Some personal injury cases don't produce physical injuries, but result in emotional trauma. Under the federal tax law, if you receive money based solely on “emotional distress or mental anguish,” then you have to pay taxes. 

Let's change the facts on Jane's car accident. Suppose Jane watches her close friend get seriously injured in a car accident with John. After the accident, Jane spirals downward emotionally. She develops migraine headaches, she has trouble sleeping, and she starts seeing a therapist. She files a claim for negligent infliction of emotional distress against John and settles the case for $50,000. Jane has to pay taxes on this income.

Emotionally Physical Or Physically Emotional? Fuzzy Law

Unfortunately, the legal distinction between tax-free physical damages and taxable emotional damages is not at all clear.

The IRS says that physical “symptoms” of emotional distress (like headaches, insomnia, loss of appetite) are not “physical” injuries but just effects of emotional distress. But the courts have also said that severe enough physical symptoms of emotional distress can rise to the level of physical injuries.

Confusing? Definitely.

The IRS also says that physical injuries generally mean “observable physical harm,” like a bruise, bleeding, cut, or swelling. But a soft tissue injury (like a back injury) is not observable, and no one would seriously argue that a back injury is not a “physical” injury.

Still confusing? Absolutely

Back to Jane's car accident, but let's change the facts again. Suppose that both Jane and her close friend are injured. Are Jane's emotional symptoms (headaches, insomnia, depression) physical manifestations of her emotional distress from seeing her friend injured (i.e. taxable)? Or are they severe enough to be considered physical injuries (i.e. non-taxable)?

No wonder that California attorney and tax expert Robert Wood has said that the physical / emotional distinction (or lack thereof) is “fuzzy” and “frustrating.” 

Medical Expenses Are Tax-Free

Medical expenses are much easier to understand, and it's all good news. Medical expense payments are tax-free, regardless of whether the case is emotional, physical, or both.

Medical care expenses (per the IRS) covers any payments for the “diagnosis, cure, mitigation, treatment, or prevention of disease, or payments for treatment affecting any structure or function of the human body.”  Pretty broad definition.

Included are hospital visits, doctor appointments, dental care, prescription drugs, crutches, reading glasses, acupuncture treatment, inpatient treatment for alcohol or drug abuse, therapy-related appointments, and unreimbursed insurance premiums. Travel expenses, including tax, bus, or train fare, out-of-pocket costs for gas and parking costs, and the standard mileage rate for medical expenses—also count.

In other words, pretty much anything you can think of fits into the medical category.

But don't get too excited. There's a caveat—three big caveats.

You can't deduct all your medical expenses

You can only deduct medical expenses that exceed 7.5 percent of your adjusted gross income (AGI). Suppose Jane's AGI is $50,000 and her medical expenses for the accident are $4,000. Jane can only deduct $500, because 7.5 percent of $50,000 is $3,750.

You can only deduct un-reimbursed medical expenses

You also can't deduct medical expenses for which you were already reimbursed. Suppose Jane has personal injury protection (PIP) coverage, which requires her insurance company to reimburse her for her medical bills, among other things. Suppose Jane's insurance company reimbursed her for all her medical expenses in December 2018. Jane then can't turn around and write off her medical expenses on her 2018 taxes. She can't double dip.

You have to itemize your deductions

When you file your taxes, you have two choices: you can take the standard deduction or itemize your deductions. You can't do both. Itemizing your deductions, therefore only makes sense if your total itemized deductions exceed your standard deduction. 

The TCJA doubled the standard deduction for everyone (now $12,000 for single filers and $24,000 for joint married filers). That's a good thing for most taxpayers, but it's really bad if you're trying to itemize. 

The Trump Tax law also eliminated a number of deductions, such as moving expenses, alimony payments, and home mortgage interest payments.

That's why the IRS estimates that nearly 90 percent of Americans will take the standard deduction instead of itemizing. Given the expanded standard deduction and the elimination of several deductions, itemizing is going to be a difficult economic hurdle for many people to overcome.  

Punitive Damages Are Taxable

Punitive damages are unique in personal injury cases. They are not technically intended to compensate a personal injury plaintiff for his injuries—they are meant to punish the defendant for bad conduct. Translation: the defendant's conduct is so bad that the jury wants to send a message.

I say “jury” because punitive damages are almost always awarded after a trial. If your case settles before trial, punitive damages won't come into play (because, obviously, a defendants are not going to settle cases on the condition that their conduct is punitive). 

Unlike compensatory damages, punitive taxes are taxable.

Consider this example: Paul is injured on an Alaskan commercial fishing vessel while working on a piece of heavy machinery. The vessel owner knew the equipment was defective but did nothing about it. Paul sues the owner and the jury awards him $200,000 in compensatory damages, plus an additional $50,000 in punitive damages. Paul pays taxes on the $50,000.

You may wonder why we're not talking about Jane's car accident and moved our example out of state. That's because Washington--unlike most states, Alaska included--doesn't generally allow punitive damages. 

Interest payments are taxable

Post-judgment interest refers to the interest that accrues from the time a Court enters a judgment until the time the judgment is paid. Like punitive damages, interest payments are taxable. And like punitive damages, interest payments will not come into play until after trial. (In Washington, post judgment interest is typically 12 percent)

Even if you receive a tax-free judgment (I.e. Jane's car accident case physical injuries), interest is always taxable.

Legal Fees are taxable

This one really hurts.

Personal injury lawyers typically work off contingency fee agreements. Basically, your attorney takes a percentage of the money you win. You win a $100,000 settlement, your attorney may take 40 percent (or more, depending on the agreement). You keep $60,000. Pretty simple. 

In fact, you typically won't even see that money. In most cases, the defendant's insurance company issues your attorney a check. You attorney puts the check into his trust account. He pays himself his contingency fee, takes out additional money to recoup his costs, and sends you a check for the balance. 

Here's the tax problem for you. The US Supreme Court has ruled that your lawyer's fee is part of your gross settlement. Suppose you win 100K in a settlement and your lawyer takes 40,000. You will be taxed on 100K even though you get only 60K.

Let that frustration sink in. You can imagine how taxpayers feel about that. 

This Supreme Court ruling has been in effect since 2005, so this isn't a new problem. There used to be a solution, and that solution was “miscellaneous itemized deductions.”

Before the TCJA, you could deduct legal fees as a miscellaneous deduction. Miscellaneous deductions were a hodgepodge of deductions like un-reimbursed work expenses, investment-related expenses, and tax preparation fees. Before the Trump Tax law, you could deduct any miscellaneous expenses that exceeded 2 percent of your AGI.

No longer. The TCJA suspended all miscellaneous itemized deductions until 2025. Maybe they'll come back in 2026 … maybe not.   

Now, finally, some good news. Recall that for purely physical injury cases, your recovery is 100 percent tax-free (Punitive damages and interests notwithstanding). The TCJA doesn't change this. 

But for non-physical cases, or cases involving emotional damages, this could be a big deal. 

How do you report your taxable income?

Assuming you have to report settlement income on your taxes, how do you report it? 

You report your taxable settlement income on Line 21 of you Income Tax Form 1040. Line 21 covers “Other Income,” which is basically a catch-all for unique, un-common types of income that most people may never have, such as jury duty pay, gambling money, or lottery winnings. 

3 Tips for Keeping More of Your Money

We've covered a lot of tax ground. Obviously, the overriding goal in any case is to maximize the compensation you receive. But now you know the key is to maximize the amount of non-taxable compensation that you receive.

How do you do that?

1. Pay attention to contingency fee

If you hire an attorney for your personal injury case, you will be signing a contingency fee agreement. Read it very carefully.

Many personal injury lawyers have escalator clauses in their agreement—they charge more as the cases moves farther along (i.e. 25 percent if the case settles before a lawsuit is filed, as much as 40 / 45 percent if the case goes to trial). So If you want to go to trial, chances are your lawyer's going to take a bigger chunk of the pie. 

This won't matter for purely physical injury cases (as we've learned, your entire award will be tax-free). But for all other types of cases, this is a huge consideration. 

2. Settlement is more tax-friendly than a judgment

You may have to go to trial to get the money you deserve, but from a purely tax perspective, a settlement makes a lot more financial sense. Put simply, you can craft a tax-friendly settlement but you can't craft a tax-friendly jury verdict.

With a settlement, you can structure favorable tax treatment. Let's return to Jane's car accident where both she and her friend are injured. Suppose that she settles all her claims (physical and emotional) for $100,000. Jane should include language in the settlement agreement that John's insurance company is paying for Jane's personal physical injuries, thus triggering tax-free income. Or, at the very least, specifying that a certain amount of money (say $50,000) is related to her physical injuries.

You can never be too specific when it comes to the settlement agreement. Like all businesses, insurance companies are required to issue you a Form 1099 if they've paid you at least $600 during the year. In any case involving physical injuries, you may want to include settlement language to the effect of: “the defendant agrees not to send a 1099 to the plaintiff for any money paid under this settlement agreement.”

Now suppose Jane settles all her claims but the settlement agreement says nothing about taxes. Very likely, John's insurance company will send Jane a 1099 for the entire settlement. Now, unfortunately, Jane has to report her entire settlement to the IRS, even the part that should definitely be tax-free. Not all is lost, however. Jane can explain in her tax returns why she shouldn't be taxed for the whole settlement (or part of the settlement), but it's really a legal crapshoot how the IRS will classify the income.

The IRS isn't legally bound by language in a settlement agreement—no matter how legally airtight. And neither are the courts. But tax expert Wood delivers good news. Settlement agreements are “rarely ignored” by the IRS and the courts. “As a practical matter,” Wood writes, “what the parties put down in the agreement is often followed.”

Unlike a settlement, you can't craft a tax-friendly jury verdict, because you are no longer in charge. That's because the jury decides how much you get paid and what types of damages you receive. If a jury decides that Jane's “emotional” damages are worth more than her “physical” damages, then Jane is going to pay more taxes.

3. You need a tax lawyer

Many lawyers specialize. Some lawyers handle only DUI cases. Others focus solely on family law. Specialization may be a good thing in some cases, but specialization can be deadly in a personal injury case.

You may think you need a personal injury lawyer to settle your personal injury case, but that's not true. You also need a tax lawyer. And I don't mean two different attorneys. You need a personal injury lawyer who understands tax law.

Because it's your money. Don't give Uncle Sam more than he deserves.

About the Author

Brian C. Zuanich

I am the managing partner at Zuanich Law. I am a former prosecutor and insurance defense attorney, and have practiced law in state and federal courts for over a decade.

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