Many of my clients often ask the question of whether the settlement he or she receives in an auto accident case is taxable income. The answer is ‑ it depends. It is important to consider this question before finalizing a settlement because the terms of the settlement might make a difference.
The general rule is that recovery for personal injuries to your body, pain and suffering or damages directly related to these types of injuries are not taxable income and need not be included in gross income for tax purposes.
One exception to this rule is that if you deduct medical expenses paid from your gross income, then you must include an income in the amount you deducted on a pro rata basis in the year that you took such deduction.
Recovery for emotional distress or mental anguish is likewise not taxable income.
Punitive damages ‑ those damages received to punish the responsible party and that are not compensating you for your injuries ‑ is taxable income. Although punitive damages are rare in auto accident cases, it can be sought and obtained in egregious cases.
If you are paid for the loss of value of personal property, the funds you received are not taxable, but the basis of your property should be adjusted downward by the amount of your settlement you receive for property damage. Thus, when you sell that item of personal property, you might have taxable income.
A person injured in an auto accident is also entitled to lost income from work or otherwise. Recovery of lost income is taxable income.
In summary, before settling a personal injury or auto accident matter, one should consider the tax implications. If lost income, punitive damages, property loss or other potential taxable income is at issue in your case, you should consult with your accountant as well as your personal injury attorney to ensure you structure your settlement in a way that mitigates or eliminates any income tax that must be paid.
For more information on the taxability of settlements, refer to IRS Publication 4345, which can be found at https://www.irs.gov/pub/irs-pdf/p4345.pdf.