Most personal injury lawsuits settle out of court. As a general rule, personal injury settlements in Arizona are not taxable under federal law or Arizona state law. Certain exceptions do exist in which part of your settlement payment may be subject to tax.
Stone Rose Law Arizona personal injury attorneys can help you understand the potential tax implications of your personal injury settlement. To schedule a free consultation with a member of our legal team, call our Scottsdale offices at (480) 631-3025 or contact us online.
What Parts of Your Personal Injury Settlement May Be Tax Free?
Common examples of non-taxable settlement-related funds include:
- Past and future medical expenses that are related to a physical injury or illness. Specific examples include medical bills for inpatient care, such as hospital stays and surgeries; outpatient treatment, such as visits to your doctor or other medical specialists; physical therapy or rehabilitation; costs for prescription medications; assistive devices, such as wheelchairs or crutches; and prosthetics.
- Damages for emotional distress are excluded from income when they originate from a physical injury or physical sickness, except to the extent they reimburse medical expenses previously deducted. This includes non-economic damages paid for emotional distress connected with a wrongful death claim, because even though you did not suffer the harm the decedent did, the entire claim is connected to the physical injury or illness that led to the wrongful death.
- Damages for loss of consortium or companionship when they arise from physical injury or sickness.
What is the Legal Authority on Personal Injury Settlement Taxation?
The Internal Revenue Service (IRS) operates under federal laws that comprise the Internal Revenue Code (IRC). The IRC has specific provisions governing the tax treatment of personal injury settlements. Here are the main ones that apply:
- Under IRC Section 61, all amounts from any source are treated as gross income, unless a specific exception exists. Amounts paid on account of physical injury are a specific exception.
- Under IRC Section 104, gross income does not include damages received on account of personal physical injuries.
- Under IRC Section 104(a)(2), you can exclude from your gross income the amount of any damages other than punitive damages you receive on account of personal injuries or physical sickness.
- IRS Regulation 1.104-1(c) defines damages received on account of personal physical injuries or physical sickness as amounts received, other than from workers’ compensation, from a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.
See IRS Publication 4345 for additional IRS guidance on tax treatment of settlements.
Why Are Personal Injury Settlements Generally Not Taxed?
The main reason why your personal injury lawsuit settlement recovery is not considered taxable income is that many of the kinds of damages you receive are meant to help you cover costs from the bodily harm done by the injuries you have suffered. In other words, tax authorities do not consider your settlement to be other income, but restorative compensation for loss.
What Parts of Your Personal Injury Settlement Are Generally Taxable?
Some kinds of sums you may receive through a settlement are not necessarily tied to compensating you for harm done to you. In these cases, the Internal Revenue Service may consider these amounts to be taxable income. Examples include:
- Lost wages if you received compensation for lost income as part of the settlement.
- Punitive damages: It is advisable that if your settlement includes an amount for punitive damages, that sum be clearly identified in the terms of the settlement.
- Interest accrued on the settlement, from the date of the injury until payment.
- Emotional distress damages that cannot be linked to a physical injury. The IRS requires that damages be connected to a personal physical injury or physical sickness; the injury need not be visible. Still, for example, emotional distress connected with the loss of income would be considered taxable.
- Amounts for medical expenses connected with your injury, if you claimed a tax deduction for them in a prior tax year, or if you subsequently were reimbursed for them.
- Breach of settlement agreement claims, if you violate the terms of your settlement agreement.
In Preparing a Personal Injury Settlement, Are My Attorney Fees Taxable?
In non-taxable personal‑injury settlements, attorney fees are generally not taxable to the plaintiff because the underlying recovery is excluded from income.
Do I Have To File My Settlement With The IRS?
Generally, no reporting of your settlement is required when all proceeds are non‑taxable, and no tax‑benefit recapture applies.
Tips for Assessing Your Settlement’s Taxability
Here are some actions you can take to reduce the chance that you might misidentify parts of your settlement as being taxable or not taxable income:
- Clearly identify the types of damages included in the settlement. Check your settlement agreement to ensure the settlement terms specify the nature of the award amounts, including sums of medical costs for physical injuries, emotional distress, or punitive damages.
- Keep detailed records of your settlement. Keep your copies of all documentation and correspondence related to your settlement. These records can be helpful if the IRS later inquires about the nature of your settlement amount characterizations.
- Consult an attorney who has experience with preparing personal injury settlements. An experienced personal injury attorney can help you during the negotiation and preparation of your settlement agreement to see that it properly identifies the types of settlement proceeds you receive for income tax identification purposes.
Call Stone Rose Law About Your Personal Injury Settlement Tax Questions
Although the IRS offers written guidance on how it treats personal injury legal settlement awards for filing taxes, sometimes the distinction between what parts or your settlement package are taxable or not can be complicated. A Stone Rose Law personal injury attorney can help reduce the chance that you will get into trouble with the IRS or the state of Arizona regarding how you characterize what you receive in settlement compensatory damages.
To speak with one of our Scottsdale personal injury lawyers, call us at (480) 631-3025 at any time to schedule a free consultation with a member of our legal team. Or you can contact our law firm through our online contact form.
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