If you’ve been involved in a car accident and have been able to get either a settlement or a jury verdict, you may be wondering whether or not the IRS will come calling to take a piece of it. The answer, like so many things related to the law (and taxes), is “it depends.”
Primarily, it depends on what the money is intended to do and how it breaks down by purpose. A claim is valued and compensated based on things such as pain, suffering, property damage, past and future wage loss, or as deterrent (punitive damages). For instance, a hypothetical award of $100,000 may break down like this:
Let’s take a closer look at each of the taxability of each type of damage.
This one is easy. You will be taxed on lost wages because you are taxed on regular wages. This is a one-to-one comparison based on a two-step theorem: (1) lost wages are intended to compensate you for money you would have earned had the accident not occurred and (2) you would have been taxed for these wages had you earned them absent the accident. Therefore, this part of your settlement or jury award is subject to taxation.
These are generally tax free, with one exception. If you have already taken deductions for the out-of-pocket medical expenses on a previous tax return, and then receive reimbursement for them, that reimbursement is subject to tax (so you can’t double dip your tax benefits).
This one can be the trickiest, because to some extent it depends on what sort of suffering you have endured. While pain, suffering, and distress all tend to blur together in general usage, the fact of the matter is that, legally speaking, money paid for pain and suffering is different than that paid for emotional distress. This matters to you because money for pain and suffering is not taxable, but money for emotional distress is considered taxable income.
The Internal Revenue Code excludes from taxable income compensation for physical injury. The operative question is, what constitutes a physical versus a non-physical injury? Pain is obvious enough, as it is physical discomfort caused by the injury. Suffering is a more fluid concept, but it may encompass things that you missed out on -- or can no longer do -- as a result of your injury. If you broke your foot in the accident, you may no longer be able to do household chores or take part in some of your hobbies. This sort of suffering arises from the physical injury. However, since pain and suffering are decided together, you won’t have to report them separately.
But your emotional suffering -- depression, anxiety, post-traumatic stress -- those are, by definition, not physical injuries. The tax code simply does not exclude them from taxable income. If you have received compensation for mental anguish or suffering, then you have to pay taxes on it. However, like other medical bills, compensation for the costs of medical treatment attributable to emotional distress is not taxable.
As a rule, any money you receive that is intended as compensation for property damage caused by your car accident (i.e., money to repair damage to your car, or the car’s “actual cash value”) is not taxable.
This is the easiest one. According to the blunt rule of the Internal Revenue Code, punitive damages are not excludable from taxes. Congress has spoken on this question several times to ensure that the code is clear on this -- punitive damages, even in conjunction with a personal injury case, arise not from the injury itself, but from the bad behavior of the defendant (behavior that these damages are intended to punish). Therefore, punitive damages are subject to taxation as income.
State laws vary widely when it comes to car accident settlements and claims, and each claim has limitations and exclusions. In addition, recovery may depend on the particular insurance policies involved as well as judicial decisions in that state. If you get into even a minor car accident, you should contact a car accident lawyer so that you learn your rights.
Updated by: David Goguen, J.D.