Are Personal Injury Settlements Taxable?

by Gina Corena

posted in Las Vegas Personal Injury Attorneys on September 27, 2022

Are Personal Injury Settlements Taxable?

The award given for a person’s injuries, medical expenses, or property damage is understood as compensation for a loss. Therefore personal injury settlements are typically tax-free because the settlement proceeds are not considered gross income. 

There are some circumstances in which Nevada may tax a portion of the personal injury compensation. Although the specifics should be discussed with an experienced Las Vegas personal injury lawyer, it can be a good idea to be familiar with the fundamentals before doing so.

What is Taxable Income? 

The portion of gross income known as “taxable income” is used to determine tax liability for a certain tax year. It can be roughly defined as adjusted gross income (AGI) less permitted standard or itemized deductions. Wages, salaries, bonuses, and gratuities are all considered forms of taxable income, as are investment income and different unearned income streams.

Settlements for where loss was incurred will not be included in taxable income. If a person pays out-of-pocket money to cover injuries or damage from an accident and is awarded compensation for those losses, the IRS will not impose any tax on this amount because it is not seen as a form of income but rather as covering a loss of income. 

Physical Injury and Physical Sickness 

The IRS does make a distinction in certain tort cases where the settlement could be taxed. The IRS will put a distinction on injury awards vs. money given for sickness. 

The entire amount of a settlement for personal physical injuries or physical illnesses is not taxed if one did not claim an itemized deduction for medical costs associated with the injury or illness in the preceding years. The settlement money should not be counted as income.

If a person receives compensation for physical injury or physical sickness, they must include it in their income for the percentage of the settlement that represents medical costs they were able to deduct in a prior year or years, to the extent that the deduction(s) resulted in a tax benefit. 

If a portion of the revenues is for medical expenses paid over the course of more than one year, they must prorate the portion of the proceeds to each of the years in which they made those payments. Information on how to figure out how much to report can be found in Publication 525 on recoveries. The tax benefit sum should be entered on line 8z of Form 1040, Schedule 1 as “Other Income.”

Settlement for Lost Wages or Lost Profits

If awarded an amount in a settlement for an employment-related case, like discrimination or unlawful termination, the portion of compensation for these categories is considered a recompense for lost wages. Income or wages are always taxable through federal and state taxes. Therefore, a settlement for these cases will likely be taxable. They will also be subject to social security withholdings and Medicare tax rates. 

Settlement for an award for lost wages must be reported to the IRS because the payor will have an employment tax withholding for the money given. Therefore, the person receiving a settlement for lost wages will need to report it as wages, salaries, and tips on line 1 of form 1040. 

Likewise, if one receives compensation for lost business profits, the part of the proceeds that can be traced back to the operation of the trade or business is considered net income and is liable to self-employment tax. These proceeds are taxable and must be accounted for as “Business income” on line 3 of Schedule 1 of Form 1040. When calculating self-employment tax, these proceeds are also taken into account on line 2 of Schedule SE (Form 1040).

What Part of a Personal Injury Settlement is Taxable in Nevada?

When it comes to personal injury claims in Nevada, the majority of the money received in a settlement will not be taxed, but some of it might be. The amount spent on medical care is one category that is subject to taxation. The money received via a settlement for the same medical care would be subject to tax if the medical care obtained as a result of the injury was already given a deductible. 

According to the Internal Revenue Service, victims who received compensation for physical injuries through a Las Vegas personal injury claim settlement but did not claim an itemized deduction for medical expenditures will not have their settlement money taxed.

Another portion of a settlement that may be subjected to taxes in Nevada is emotional distress. Emotional distress is common in personal injury cases and will not incur taxes if it is claimed as a damage due to suffering from an injury after an accident. Emotional distress will be taxed when it is a component of a claim that is unconnected to an injury or illness from the accident. 

Taxation of Punitive Damages

Punitive damages, also known as exemplary damages or exemplary punishment, are financial penalties imposed on the defendant for egregious behavior and/or to reform or prevent the defendant and others from repeating the actions that gave rise to the litigation.

Punitive damages are always subject to taxation. The plaintiff’s attorney will always request that the judge or jury divide the judgment into compensatory damages and punitive damages if pursuing a punitive damages claim. This makes it possible for filers to explain to the IRS that the jury’s decision included compensatory damages, which are not taxable, and a portion that is taxable. 

In addition to punitive damages, interest on a judgment is also taxable. If a case is pending in the court, it will typically incur some form of interest during that time. Any interest applied will need to be reported to the IRS and taxed. 

Ensuring Non-Taxable Settlements

Reporting taxes to the IRS is a serious matter, and one never wants to forget to report earnings. If you are ever questioning reporting a settlement or parts of a settlement, an attorney can help go over what, if any, portions of the settlement need to be reported to the IRS. 

If not properly reported, the IRS may challenge the non-taxability of a settlement. After receiving compensation for a court case, it is best to seek the advice of an experienced attorney before filing your next tax return. 

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