THE FOLLOWING INFORMATION IS NOT TAX ADVICE. ALL TAX DECISIONS SHOULD BE DECIDED WITH A TAX ADVISER WHO KNOW YOUR SPECIFIC CIRCUMSTANCES.
If you have been injured in a car accident caused by another driver's negligence and are seeking reimbursement of damages in a personal injury claim, it may surprise you to learn that a portion of your settlement may be taxable. Plan ahead to avoid being hit with an unexpected tax bill.
Tax Liability for Personal Injury Settlements
Your tax liability in a personal injury settlement depends on the type of damages you receive. Liability is briefly outlined in IRS Publication 4345, Settlements Liability.
Key points to remember include:
- Medical expenses: Funds used to pay for your medical expenses are not taxable. However, if the funds are provided to reimburse you for medical expenses that you previously deducted from your tax return, a portion of the settlement may be taxable.
- Property damage: Money intended to compensate for vehicle repairs, a totaled vehicle, or a rental car while your vehicle was in the shop is not taxable.
- Lost wages: Any portion of your settlement intended to compensate for lost wages is fully taxable, since you would have been liable for income taxes on your salary if you were working.
- Lost profits: If you are a self-employed business owner, compensation for lost profits is taxed as ordinary income and may be subject to self-employment tax.
- Pain and suffering: Compensation for physical and emotional distress related to the accident is not considered taxable.
- Punitive damages: Intended to punish the defendant and act as a deterrent against future bad behavior, punitive damages are rarely awarded in a personal injury suit. However, if you do receive this type of compensation, the funds are almost always taxable.
- Settlement interest: If you are receiving interest on a settlement, it is generally considered taxable as interest income.
- Attorney's fees: Personal injury cases are typically handled on a contingency fee basis, with an attorney receiving a portion of the settlement in exchange for his services. For tax purposes, however, you are considered to have received 100 percent of the settlement. This means you must include the portion of the settlement reserved for your attorney's fees in the taxable recovery.
Effect of Going to Trial on Tax Liability
In most cases, it does not matter whether you settle your personal injury claim out of court or go to trial. Money from a settlement at the claim stage or awarded through a judgement following a trial is subject to the same tax laws. When determining if you should go to trial, you should weigh the strength of your case against the added time and expense of litigation.
Strengths of Settling Your Case on Tax Liability
In many instances, the settlement documents can define the nature of the settlement payment to help minimize tax liability. The damages can be allocated to one type of damage or another to help reduce the possibility that the settlement will be taxable. These settlement arrangements can significantly alter the taxability of the payment.
Making Estimated Tax Payments
Personal injury settlements may trigger a liability for estimated tax payments if you are expected to owe $1,000 or more after subtracting credits and withholding. Review IRS Publication 505, Tax Withholding and Estimated Tax, and Form 1040-ES, Estimated Tax for Individuals, for details.
If you are required to make estimated tax payments and fail to do so, you may be charged a penalty. You can be charged a penalty for late payments, even if you end up being owed a refund when you file your annual return.
Consult an Accountant for Details
It is important to determine how tax liability will affect your personal injury settlement, since being responsible for unanticipated taxes could make an otherwise fair offer inadequate for your needs. However, a personal injury attorney is only equipped to offer general guidelines regarding what types of damages are taxable. For advice that is specific to your situation, you will need to consult an accountant for details.
Contact Inland Empire Law Group
Maximizing the size of your personal injury settlement requires careful documentation of damages, evidence to support claims of the defendant's negligence, and expert negotiation with the insurance company. To protect yourself, you need an experienced personal injury attorney in your corner.
Inland Empire Law Group's dedicated legal team is committed to helping California residents who have been injured due to the negligence of others receive the personal injury compensation they need to move forward with their lives. Call today to schedule a free, no-obligation consultation at our Rancho Cucamonga or Victorville offices.