Let’s say that you were terminated from your job illegally and with the help of a New Orleans truck accident lawyer, you filed a discrimination claim. Or your vehicle was rear-ended at a stop sign, you were injured, and you filed a personal injury claim. You later received a settlement out-of-court, or you were awarded a judgment by a jury.
And now it’s tax time. Is your judgment or out-of-court settlement taxable income? The answer is, “It depends.” A number of factors are taken into account by the IRS (Internal Revenue Service) when your judgment or settlement is considered.
#1. JUDGMENTS AND SETTLEMENTS ARE TAXED THE SAME WAY
It does not matter if you settled your case out-of-court or if your case went to trial. The same tax rules will apply. However, if you settled the case, you may have more ability to reduce the amount that you will owe.
If you are audited, you will need to produce copies of the settlement agreement and all related financial documents.
#2: HOW YOUR RECOVERY IS TAXED WILL DEPEND ON WHAT IT REPLACES
A judgment or settlement is taxed based on the “origin of the claim.” This means if your business prevails against a competitor for lost profits, your recovery is taxed as business profits. But if you are laid off and you prevail with a discrimination claim, your recovery is taxed as wages.
However, let’s say that a negligent contractor working at your home damages the home, and you prevail with a claim for damages. Your compensation is not considered income but is instead considered as a drop in the purchase price of your home.
#3: A RECOVERY FOR PHYSICAL INJURY OR SICKNESS IS NOT TAXABLE
If you are physically injured or become physically ill because of another party’s negligence, and your personal injury claim prevails, you will pay no taxes on your judgment or settlement.
Prior to 1996, damages paid for emotional distress or for character defamation, for example, were also not taxable, but today you must be physically injured or physically ill in order for your settlement or judgment to be entirely tax-free.
IRS rules require that injuries in these cases must be “visible,” so if you recover damages for “emotional distress,” those damages are going to be taxed.
#4: PHYSICAL SYMPTOMS OF DISTRESS ARE NOT CONSIDERED “INJURIES”
All compensation received for physical signs of distress – such as headaches or stomach aches – is taxable. If you developed an ulcer because you were a victim of workplace harassment, and you were compensated an additional $50,000 for that reason, that amount will probably be taxed.
#5: MEDICAL EXPENDITURES ARE NOT TAXABLE
Here is where the IRS rules are somewhat illogical. You cannot escape paying taxes on damages that you receive for emotional injuries, and as mentioned previously, even headaches and ulcers may be considered “emotional” rather than physical injuries.
However, if you seek medical treatment for emotional injuries, and if you are compensated for the cost of that treatment, compensation for medical treatment is not taxable. Moreover, “medical treatment” can include a psychiatrist or a physical therapist as well as “nontraditional” treatment.
#6: FORMALLY CATEGORIZING DAMAGES CAN HELP YOU SAVE
When a lawsuit prevails, multiple issues are almost always involved. In a personal injury case arising from a traffic accident, you might be compensated for medical bills, lost wages, vehicle damages, physical pain, and emotional suffering.
To determine what is and isn’t taxable, it’s best if plaintiffs and defendants can agree in writing to itemize exactly how much is being paid for each part of the claim. A breakdown of the damages will not be binding on the IRS, but unless you are audited, it will probably be accepted.
#7: IS YOUR RECOVERY CAPITAL GAIN OR “ORDINARY” INCOME?
If your lawsuit compensates you for damage to your home, your company’s factory, or another property, the IRS may classify that compensation as capital gain.
However, depending on a property’s tax basis (your purchase price plus improvements and minus depreciation), your compensation might be considered a recovery of basis and not income.
#8: ATTORNEY’S FEES ARE TRICKY
The IRS considers you to be the recipient of one hundred percent of your compensation. However, if your attorney worked on a contingent fee – like most personal injury lawyers – your attorney may be paid his or her percentage directly by the defendant.
You may never see that money, but you might still be taxed for it. If your recovery is entirely non-taxable – like a recovery that is exclusively for a personal physical injury – you will not be affected, but if your recovery is taxable, you might have to pay taxes on the attorney’s fee.
#9: PUNITIVE DAMAGES ARE ALWAYS TAXED
In most states, if you are injured in a traffic collision and receive both punitive and compensatory damages, the compensatory damages are tax-free. The punitive damages are not.
However, punitive damages are rarely a concern for taxpayers in Louisiana. This state generally does not allow the recovery of punitive damages in personal injury cases.
WHAT’S YOUR BOTTOM LINE?
In matters that generate lawsuits, many plaintiffs want to resolve the issues swiftly, get the case over with, and worry about the taxes later. Don’t do it that way. The tax rules for recoveries are filled with nuances, restrictions, and exceptions, so you must take the rules seriously.
Consider the tax aspects and discuss the details with your attorney before you file an injury claim or take the case to court. When you consider your tax consequences from the beginning, you may be able to save yourself a substantial amount in taxes.
If you are injured by another person’s negligence, it is important to act quickly and contact an injury attorney at once to determine if you have grounds for legal action. A good personal injury lawyer will work diligently and fight hard for compensation – and justice – on your behalf.
What has been discussed here are the general rules for taxes and compensation, but every case is different. If you have been injured and you need to learn more, discuss the details of your case with an experienced New Orleans personal injury attorney.