Since it is that time of year again that all Americans love (paying Uncle Sam), it is essential to know the ins and outs of what you owe to the taxman on your injury settlement check. 

Likely, it is the most money you have seen at one time in your whole life.  So, the old adage of spend wisely couldn’t be more apt. 

Here’s why…

Meet my injury prone friend Clumsy Bill.  Clumsy Bill gets in all sorts of trouble when he is driving the streets of New Orleans.  He’s been in one too many accidents – and,  as a result, he is not quite right in the head.

Meet his wife Careful Betty.  Being a woman, Careful Betty has inherited genes that makes her far superior to her husband Clumsy Bill.  She never gets into accidents (except when Bill is driving) and always keeps a level head.

Why they ever got married, her mother Nancy will never know, but, Careful Betty and Clumsy Bill are madly in love despite their different inherent abilities.

One fine day, Clumsy Bill is driving Careful Betty to get her hair done.  As he is texting on his phone in a busy intersection – despite admonitions from his wife – his car is struck on the passenger side by a 1957 Mint Green Buick Skylark, being driven like a bat out of hell by Dumb Dave, who, incidentally, wanted to know what it felt like to intentionally slam into a car (he must have seen Fight Club the night before).

Both Clumsy Bill and Careful Betty are seriously injured.  They miss several weeks of work and both have permanent injuries preventing them from doing the type of work they did before. 

They are promptly fired from their jobs.

After many weeks and months of moping, they reach out to their friend, an experienced car accident attorney in Louisiana (it might even be me).

After a few months of negotiations, State Farm, the liability insurer, and GEICO, the Underinsured Motorist Insurer, settle for the full policy limits of each policy (wow, I’m really that good?).   

Additionally, their enlightened attorney sued their employers for wrongfully terminating them under federal laws and secured a separate settlement for that case. 

Clumsy Bill and Careful Betty are ecstatic at the settlement money they receive.  Clumsy Bill can’t wait to spend it on a vacation from all of the madness this accident has created in their lives.  He dreams of all the exotic places they can go and experiences they can share together.

Meanwhile, Careful Betty knows better.  She knows the taxman sometimes dips his hand in pockets that are unsuspecting.  She wants to make sure the money they got is all theirs, or, if they must reserve some for Uncle Sam. 

So…Careful Betty books a visit with their accountant, Savvy Steve.  Savvy Steve tells them he is glad they came to visit because, indeed, all the money is not their’s to keep. 

Here is the breakdown under federal laws…

Try and figure out which ones require tax payments and which ones are exempt. 

When a personal injury award is made by settlement or by a jury there is a breakdown of different types of damages: compensatory and punitive. 

Compensatory is meant to put the victim back in the place they were before the accident by paying them.  Within these there are special damages (medical bills, lost wages) and general damages (pain and suffering, mental anguish).

Punitive damages are meant to punish someone for intentionally or recklessly inflicting harm on the victim.  These are meant to deter extreme behavior.  The types of damages are:

Lost wages past and future

Pain and Suffering

Medical care past and future

Loss of Consortium

Mental Anguish

Punitive Damages

Did you figure it out?  I’ll give you a clue…some of these have tricky answers.

In this scenario, almost all of these are tax exempt with some caveats…

If Bill and Betty took an itemized deduction for past medical care and received a tax benefit in a prior year’s return due to this accident (meaning the settlement check straddled two different tax years), B&B will have to pony up and pay Uncle for the money they received back in the settlement (i.e. no double dipping) that was deducted in the prior year’s return.

If Bill’s mental anguish is due to witnessing Betty’s horrific experience, he would have to pay taxes at ordinary income rates because it is not his physical injuries that are causing this distress. 

However, if his mental anguish is due to his own experience from physical injuries he sustained, he would not have to pay taxes at all (assuming he made no deductions for this on prior returns). 

Same with Loss of Consortium and Pain and Suffering.  These are compensatory damages.  Therefore these are not taxable because they are not “earned income” but compensation to return the victim to her original state of being.

Bill’s and Betty’s future and past lost wages claims arising out of their personal injury are taxable because these would be taxed anyway had they actually worked for it. 

Punitive damages are almost always taxable.  So Dumb Dave will have to pay for his devilish ways.

However, in their employment discrimination settlement, all of the proceeds are taxed assuming no physical injuries resulted from the discrimination itself.  Depending upon the basis for the claim, their attorney’s fees can be deducted “above the line,” such that their gross income is reduced to a lower adjusted gross income.  If they don’t do this, they would be paying taxes on their attorney’s fees, even though that money was never theirs. 

The premise for these statements comes directly from the IRS.  You can read about it here at: https://www.irs.gov/pub/irs-pdf/p4345.pdf for a detailed summary of the above.

The moral of the story is this…it is better to be a Careful Betty than a Clumsy Bill. 

Just like you would hire an accountant who knows how to count and make proper deductions, you want to hire an attorney who specializes in the area where you were injured, especially when it comes to car accidents and medical malpractice.  These two areas are highly specialized arenas (despite what you think of the attorneys you’ve met and seen on television). 

At the Reddy Accident Law we make a difference in the lives of our clients by giving personalized, individualized attention to our clients.  We focus solely on car accidents and medical malpractice because it takes 10,000 hours of study in each specialization to become the Tony Robbins of these niche practices. 

I’m interested in learning if any of you have experienced difficulty with the IRS when it came to reporting settlement proceeds income.  Please leave a comment below.