After all your hard work in pursuing a personal injury claim, you’ve finally agreed to a settlement. Your settlement will be a financial windfall. However, you must be cautious about managing those funds, especially when preparing for tax day after a settlement.
The amount of your settlement will be carefully calculated between you and your personal injury attorney. It is designed to compensate you for all the losses you’ve suffered due to an accident caused by someone else’s negligence. Here at Frost Law Firm, PC, we take great pride in the settlements we’ve helped our clients achieve.
We also don’t want to leave them in a lurch when it comes to handling a potentially large sum of money. The following blog explains some of the basics of the tax laws that would apply to your personal injury settlement.
Understanding State and Federal Taxation
Like it or not, taxes are part of our lives. Any amount of money that comes your way that is considered a gain can be taxed. Many states, such as Florida, Nevada, and Washington, do not charge any state income tax. California is not on that list.
Here in the Golden State, the California Franchise Tax Board oversees the collection of taxes for every resident. Those taxes are paid in addition to the Internal Revenue Service (IRS), which collects taxes on behalf of the federal government. Everyone in the country is obligated to pay taxes based on their income. Currently, the federal tax code contains 6,871 pages of rules and regulations that would be a challenge for anyone to understand.
When it comes to your personal injury settlement, there are a few tax exemptions and obligations you need to be aware of based on the category of the settlement.
Past and Future Medical Expenses
According to the state and federal tax code, the compensation you receive for your medical expenses would not be considered gross income.
That means they are not taxable by the IRS or California. These are considered reimbursements for the money you owe doctors, therapists, or hospitals. Typically, if you have outstanding medical bills on the day your settlement check comes in, those expenses will be paid directly by your attorney. This is not considered a gain.
The exemption in this category would be if you made itemized deductions for any medical expenses, such as modifications to the home or special medical supplies.
If you’re reimbursed for those expenses through the settlement, you would have to report that amount to the IRS. On the other hand, if you applied the standardized deduction without itemizing your medical expenses, none of the settlements you received for medical expenses will be taxed.
Past and Future Lost Wages
During your recovery, you will miss out on work. You are entitled to receive compensation for the lost wages. Those funds are supposed to replace your income. You would be paying taxes on that income if you hadn’t been injured. The same rule applies to settlement funds for lost wages.
Those would be considered a gain and would be taxed by the IRS and the state.
Property Losses
If your injury was the result of a car accident, you could be compensated for property damage. If this money goes to repairing or replacing your car, it is considered a reimbursement and not a gain.
That means it is not taxable. The exemption will be if you are paid damages for the reduction of the value of your car.
For example, an accident that causes $20,000 in damages could also mean you lost $5,000 in value in your car. That would mean your award would be $25,000. The difference between the damages and the lost value ($5,000) would have to be reported to the IRS because that is considered a gain.
Pain and Suffering
Non-economic damages in a personal injury lawsuit cover pain and suffering. These are not backed up with a bill but could be calculated using the multiplier or per diem method. This category would also include compensation for mental anguish associated with the injuries. Fortunately, these rewards are not considered to be taxable income because they are associated with the injury.
On the other hand, if you receive a settlement directly for non-economic damages that are strictly for emotional issues without any physical injury, they would be considered taxable.
Punitive Damages
Punitive damages are typically awarded in a lawsuit presented to a jury. These are damages meant to serve as a punishment against the at-fault party for outrageous actions such as driving drunk and causing an accident. This would be considered a gain that you must report to the IRS.
Breaking Down Your Settlement
When your personal injury attorney presents a demand letter for a settlement, they will most likely present an itemized list that breaks down the specific damages you’re seeking. When you finally receive your settlement check, it will be a lump sum. You will have to break down the specific amounts and how they relate to what you asked for.
Dealing with taxes is inherently complicated. Fortunately, Frost Law Firm, PC, has a lot of experience disbursing settlements to our clients. We also have a good understanding of the state and federal tax laws. We can provide the guidance and information you’ll need to ensure you won’t get hit with taxes you don’t need to pay.
Call to discuss what happened in your accident, and we’ll talk about your options for a settlement.
