Whenever an American citizen receives any kind of substantial windfall there is a high probability that individual will incur a sizeable tax burden on the proceeds he or she earned. This includes lottery winnings, some types of inheritances, and even legal settlements and cash awards. However, federal and state laws exist that prevent excessive taxation of plaintiffs’ legal proceeds. All personal injury plaintiffs should know what to expect when it comes to their tax obligations after winning a personal injury claim.
Generally, a settlement or cash award for a personal injury lawsuit for a physical injury or illness is exempt from taxation. However, some exceptions apply. Some personal injury cases may last for months or even years before a plaintiff sees any kind of financial recovery. In the meantime, they must typically manage their medical expenses and other economic concerns on their own. If a plaintiff happened to take an itemized deduction for medical expenses in prior years, those medical expenses would no longer qualify as tax-exempt in the following years. This would essentially be “double-dipping” on a tax benefit.
If a plaintiff receives a cash award or settlement for a physical injury or sickness but did not take any itemized deductions for those expenses previously, the settlement or case award is tax-exempt. If part of the plaintiff’s medical expenses occurred during the previous tax year and the plaintiff claimed an itemized deduction, the plaintiff must use a pro rata formula to determine his or her tax obligation on the remainder of the medical expenses incurred following the previous tax year.
Tax-exempt status for qualifying physical sickness or injury applies to other related types of compensation in the same case. For example, if a plaintiff secures pain and suffering compensation related to his or her physical injury or illness, those damages would be tax-exempt as well.
Some personal injury claims involve related claims for other types of damages. For example, a plaintiff may file a lawsuit against a defendant for breach of contract and a related personal injury. The plaintiff and the plaintiff’s attorney must work carefully to determine the appropriate amount of damages associated with each claim. Additionally, if the plaintiff secures a settlement or cash award, the plaintiff’s attorney should request a fully documented breakdown of the plaintiff’s damages and to which claims they apply.
Following the previous example of a personal injury claim and a related breach of contract, the proceeds gained from the personal injury damages would be tax-exempt, but any damages recovered for the breach of contract would not. Tax exemption only applies to damages and compensation received for physical injuries and illnesses caused by negligence.
Lost wages also qualify for taxation under all applicable taxation laws. For example, if a plaintiff secures compensation for one year’s worth of lost work, the plaintiff would still need to pay income tax on those proceeds since they technically qualify as taxable income.
Some personal injury cases can take quite a long time to resolve, and a plaintiff may need to wait sometime not only after filing a claim but also after receiving a judgment until the defendant starts paying. During the time between the plaintiff filing suit and the time the defendant begins to pay the plaintiff, his or her damages, the cash value continues to accrue interest.
For example, a plaintiff files suit on January 1, 2020, and the judge rules in favor of the plaintiff on January 1, 2021. The defendant appeals the decision but loses the appeal and does not actually start paying the plaintiff until January 1, 2022. In this situation, the case award would accrue interest from January 1, 2020, until January 1, 2022, and the interest gained is taxable.
Punitive damages are always taxable. Unlike other personal injury compensation types that aim to repay a plaintiff’s losses and make him or her “whole” again, punitive damages punish defendants for egregious negligence, a clear disregard for the safety of others, or criminal acts that lead to civil damages.