Bar News - August 17, 2016
Workers’ Comp & Personal Injury: Determining the Taxability of Personal Injury Settlements and Awards
By: Chris Almeida
Donna was driving home from work one afternoon last year when Tom blew through a red light and T-boned her car, badly damaging it and breaking her leg. During the weeks following, she spent a good deal of money out-of-pocket on medical expenses, which she deducted on her 2015 tax return. She is still in need of physical therapy, however, and she lost some wages for a few days after the accident, when she couldn’t work – partly because she was in the hospital, and partly because her car was in the shop. Moreover, Donna’s injuries caused her to experience much pain, and she’s been plagued with insomnia, due to her worry over the accident-related expenses. Donna continues to receive medical attention to help her with the insomnia and has paid for those services herself.
A couple of months after the accident, Donna sought legal advice and representation in a suit against Tom. With the help of her lawyer, she received a substantial award this spring on a number of different claims, including damages for physical injury, pain and suffering, emotional distress, lost wages, and property loss. No punitive or enhanced compensatory damages were awarded, however.
Looking ahead to the next tax season, Donna needs advice. Unsure what portion of the award to include on her 2016 tax return, if any, she asks her lawyer to explain the rules concerning taxation of litigation proceeds, so that she will be better able to manage her finances and plan for any tax obligations.
Internal Revenue Code Section 104(a) provides that an award for compensatory damages in a personal injury case is not generally includible as gross income if the damages are received on account of personal physical injury. Therefore, if a personal injury case does not revolve around a physical injury, as would be true in a defamation or discrimination lawsuit, any damages awarded will most likely be includible as gross income. Likewise, punitive damages are generally included.
If a plaintiff has already deducted medical expenses on a previous year’s tax return, then any award meant to compensate for the deducted expenses must be included in gross income. This is because the plaintiff has already received a tax benefit for these expenses. In Donna’s case, the award she received for expenses related to the treatment of her broken leg is non-taxable only to the extent the award exceeds the out-of-pocket expenses she already deducted on last year’s tax return.
Donna’s award for the physical pain she experienced during and after the accident stems directly from her injury; accordingly, it is entirely excludible from gross income under Section 104(a). In contrast, the award for emotional distress due to Donna’s insomnia is excludible only to the extent it is directly related to the physical injury. By itself, insomnia is not considered a physical injury. However, if some portion of Donna’s emotional distress would have occurred even in the absence of the physical injury – such as worry over expenses related solely to the damaged car – then the part of the award attributable to that aspect of her distress would be includible as gross income. Nevertheless, any award meant to reimburse Donna for insomnia treatment bills will be excludible from gross income, so long as she did not deduct them on last year’s return.
This brings us to Donna’s property damage award. Tom will have to pay Donna the cost of repairing her damaged car. Is this award taxable? The short answer is no; the award that Donna receives for the damage done to her car is non-taxable. However, she must reduce her basis in her property (car) by the amount of the settlement. If the settlement amount exceeds Donna’s adjusted basis in the car, the money that exceeded her basis becomes includible as gross income.
Lastly, we address Donna’s award for lost wages. The determining factor is whether the lost wages arose out of the physical injury. In this case, Donna could not work for several days while she was in the hospital because her injury prevented her from getting to work. Once she was home from the hospital, she had several more days of lost wages while her car was being repaired because she had no other transportation. The portion of the lost wages award attributable to the physical injury is excludible from gross income; the rest is not.
It is important to note that the interest accrued from the beginning of the lawsuit till the payment is made is always considered includible as gross income. The same applies to punitive damages, with one exception. In states that allow for punitive damages only in wrongful death actions, awards received under these circumstances may not be taxable.
Chris Almeida is an intern for the Low-Income Taxpayer Project (LITP) at the NH Bar Association and a student at the University of New Hampshire School of Law. He is grateful to the LITP Coordinator, Barbara Heggie, for her assistance with this article.