After you have been injured in an accident, hired a lawyer, and taken the matter to court, it may feel like your personal injury payment will never come. There may be bills to pay and arrangements to be made that depend on receiving that money. But before you spend it all, be sure to talk to your attorney and an accountant or tax preparer to find out how much of your personal injury settlements are taxable in Connecticut, and how much you will owe to the IRS. Are personal injury settlements taxable?
Unfortunately, it isn’t always clear whether personal injury settlements are taxable. The IRS maintains the general statement that damages received as a result of personal injuries are not taxable as income. The same is true for Connecticut state taxes. However, there are a lot of exceptions and limitations on that general statement that can result in a big tax bill after your case is settled.
The IRS does not require you to pay taxes on personal injury settlements related to:
These damages often make up a significant part of the personal injury settlement. The IRS has said they do not count as income and do not need to be reported on your annual tax return.
The amount of damages paid in personal injury settlements is often calculated based on the medical expenses you have already incurred, and the amounts you expect to pay for those services in the future. If you have already paid medical expenses and deducted them from your taxes as part of an itemized income tax return by the time you receive your personal injury settlement, you may need to account for that portion of the settlement you took as past deductions. This is true for:
If those medical expenses span more than one tax year, it is your responsibility to allocate the deductions to each year, and include them as “other income” on your tax return.
Often, a personal injury settlement also includes compensation for the time you had to take off work to recover. If you have substantial ongoing injuries, it could also include disability damages that account for future earnings that you would have received, had it not been for the accident.
Lost wages, lost profits, and future earnings awards are all considered income by the IRS. You will need to separate out that part of your personal injury settlement and report that amount as income for the tax year in which you receive the money.
According to the IRS, you are not allowed to claim deductions for legal fees related to personal matters, including personal injury lawsuits. If your personal injury lawyer is working on a contingency fee, the firm is entitled to keep a portion of any personal injury settlement or verdict. However, you will still need to calculate your reportable income from the full amount, not the smaller payment you receive after your attorney is paid.
Personal injury settlements can also include awards for property damage. For example, in an auto accident case, you may be entitled to compensation for the cost to repair or replace your vehicle. Here, the tax issue gets complicated. The IRS says that settlements for less than the “adjusted basis” of your property are not taxable, as long as you reduce the basis of the property by the amount you received. However, if you receive more in property settlement than the item is worth for tax purposes, the difference is considered a capital gain and must be reported.
Determining the “adjusted basis” of your property depends on its age, the amount you bought it for, whether you have made improvements, and how you have reported the item in the past. If your personal injury settlement does include significant property damages, you should speak to an accountant to find out if any of it needs to be reported as a capital gain.
Personal injury lawsuits against insurance providers often result in the injured person receiving interest on the premiums owed that were not paid in a timely way. The IRS says that that interest is taxable as “interest income” just the same as if you had the money in a savings account the whole time.
Punitive damages are almost never included in a personal injury settlement, since they are designed to punish the defendant. However, they can make up a large portion of a personal injury jury verdict. When they do, you should be especially careful to set away a portion of that amount for taxes. The IRS counts punitive damages as “other income” and will include them in calculating your adjusted gross income. Because punitive damages often get paid all at once, this can push you into a higher tax bracket for that one year, causing all your income to be taxed at a higher rate.
Because the IRS and Connecticut state tax laws require you to report some types of damages but not others, it is important for your personal injury settlement to be clear about how the money is allocated. Lump sum awards can sometimes create problems for taxpayers who don’t know how much they need to report, or whether that income counts as wages, other income, or capital gains. Work with your attorney to understand what the money you are receiving is paying for, and what you will need to report on your tax returns.
At The Lebedevitch Law Firm, our personal injury attorneys want to make sure you have enough money to pay your bills after a car crash or other accident. We will work with you and your accountant in reaching a personal injury settlement, so there will be no surprises when tax season comes. Contact The Lebedevitch Law Firm today to schedule your free consultation.