In California, the majority of personal injury settlements are not taxable. However, some types or categories of damages listed on a settlement are subject to taxation on both a federal and state level. It is important to understand the taxation of your specific settlement agreement, and how to minimize your tax liability as much as possible with help from an experienced personal injury attorney in San Francisco.
Most Settlement Damage Categories Are Not Subject to Taxation
Personal injury settlements are organized into various damages, or specific losses suffered by the victim or plaintiff. Most settlements include damages such as past and future medical expenses, lost wages, property damage, disability, and pain and suffering.
For the most part, compensation awarded to cover a plaintiff’s economic and non-economic losses is not classified as taxable income by the Internal Revenue Service (IRS) or California Franchise Tax Board. Therefore, it is not subject to taxation.
Internal Revenue Code Section 104 states that, for tax purposes, “gross income” does not include:
- Workers’ compensation benefits
- Compensation for physical injury or physical sickness
- Amounts received through accident or health insurance for personal injuries or sickness
As long as a settlement is awarded for a physical injury or illness, amounts given to a plaintiff to reimburse both economic and non-economic losses will not be taxed by the state or federal government. These tax rules apply whether a settlement is given to a plaintiff as a lump sum or a structured settlement (periodic payments).
Are Personal Injury Settlements Taxable in California?
Portions of a Settlement That Are Taxable in California
The average plaintiff in California will not have to pay taxes on any financial recovery achieved through an insurance claim or personal injury lawsuit. Some settlements, however, have unique damage categories that are subject to taxation:
- Punitive damages (awarded to punish a defendant for especially wrongful acts), with the exception of punitive damages awarded for wrongful death.
- Damages awarded for emotional distress without physical injury.
- Damages awarded to compensate for economic losses in an employment-related lawsuit, such as for discrimination.
- Any interest earned on an unpaid settlement or judgment award.
- Awards that are granted in excess of actual damages, such as $30,000 awarded for a vehicle with an actual value of $15,000 (the difference will be taxed).
- Any medical expenses that were previously claimed as deductions in prior tax years.
If compensation is collected for these damage categories specifically, the recipient will legally need to report these amounts as taxable income. The potential taxation of portions of a settlement is why the agreement should be divided and organized into clear damage categories.
How to Minimize Your Tax Liability as the Recipient of a Personal Injury Settlement in California
While you may not be able to avoid paying taxes on portions of your personal injury settlement in some circumstances, smart strategizing and clear settlement structuring can minimize your tax liability as much as possible.
An experienced personal injury attorney in California can help you structure your settlement in a way that minimizes its taxable portions. Your attorney can ensure the settlement is organized into clear, well-documented sections to prevent the IRS from misclassifying portions as taxable.
Clear and deliberate damage documentation is key to avoiding excessive taxation as a settlement recipient in California. For legal advice regarding the taxation of your specific personal injury settlement, contact Jacoby & Meyers for a free legal consultation with a lawyer near you.