The quick answer is no. But read on as there are instances in which you may have to pay taxes on a personal injury case. The Internal Revenue Code, Section 104(a)(2) exempts “income” awards from personal injury and physical sickness awards. However, it is the substance of the transaction, not the form, or paperwork, that determines whether a settlement or jury verdict is taxable under the law and regulations. The test is the origin of the claim, or, as the Court in a 1944 case stated, “In lieu of what were the damages awarded?”
In 1996 Congress amended the law stating that for damages to be non taxable, there must be a “physical” injury. In fact, a Supreme Court ruling provided the test to determine if an award for personal injury damages was taxable: the damages must 1. be grounded in tort, or civil wrong, and 2. be on account of personal physical injury or sickness.
Are All Personal Injury or Sickness Damages are Excluded from Taxes?
No. Damage awards that are from emotional distress only are taxable. That is, if you suffer a physical injury, but have significant emotional distress as a result of your injury or disfigurement, the damages you are awarded for that distress are not taxed. But if your case involves emotional distress because of someone’s actions, such as a breach of contract, or landlord tenant issues, and there is no physical injury or sickness, any award is taxable. The test is whether there is a “direct link” between the physical injury and the damages.
Second, even if there is an injury, you need to be a named plaintiff. Thus, if you file suit for your injured child, and you are not named as the plaintiff, but end up with damages paid to you, those monies are taxable.
Third, prejudgment interest on a judgment for personal injury is taxable. In Massachusetts, prejudgment interest is 1% per month; thus, if your case takes two years to get to court and you win $100, the prejudgment interest is $24. This part is clear, however, what about a settlement after a verdict for the injured party? The courts have looked at the proportion of the verdict and prejudgment interest in any subsequent settlement. They want the same or similar proportion. There is an exception to this, however: if a settlement post judgment is based on both sides agreeing that a new trial would have been awarded and the judgment would have been higher.
Wrongful death from a personal injury has two parts to damages: personal injury for pain and suffering before death, which may extensive or may be nominal if there was an instant death; and, the wrongful death action. The pain and suffering damages are included in the estate for tax purposes; that is, they are not taxed as income, but added to the estate to determine if there is to be a tax. Damages for the wrongful death, however, are excluded from the taxable estate.
Finally, any “punitive damages,” even if derived from a personal injury, are taxable. This would include 93A and 176D damages from injuries from insurance companies that make unfair claims settlements and are later ordered to pay double or treble damages and attorney fees. The underlying damages would not be taxable, but the multiple damages would. Legal fees, which become a part of the “gross award” would also be taxable. With the assistance of an experienced tax lawyer, a properly drawn trust can spread these taxes out over 20 years, however
What About Taxes on My Legal Malpractice Cases?
The way the IRS Code is written, everything is taxable absent a specific exemption. Legal malpractice cases are derivative of the underlying case. If the underlying case were based on a physical injury, resolution in a legal malpractice case would clearly be excluded from taxes. What if the underlying claim was for a breach of contract, employment dispute or some other matter where there is clearly no physical injury? The IRS would have a good argument that the damages are taxable.
When Do I Talk To Someone About the Taxes on My Personal Injury Damages?
Now! Before you settle a claim, before you file a lawsuit, and before you give up your appeal rights, talk to your lawyer about the tax ramifications. It can make a huge difference. Attorney Neil Burns, who is not a tax lawyer, but works with the best tax lawyers in Boston, has decades of experience. Call for a free consultation: 617-227-7423.