If you are in the process of settling a personal injury claim, the allocation of damages is critically important because an incorrect allocation can result in taxable income. Generally, a recovery from settlement or judgment is excluded from income if it is a result of physical injury or physical sickness. Damages include, but are not limited to, elements such as medical and legal expenses, pain and suffering, lost wages, and emotional trauma. There are a few exceptions to this rule.
The first exception is that punitive damages are taxable. Second, any amounts received that are attributable to interest is taxable. Third, if the taxpayer has deducted any of the expenses related to the settlement, the amounts previously deducted are taxable. Finally, any portion of the recovery that is allocated to property damage is taxable to the extent that it exceeds the basis of the damaged property.
For example, say you were dragged off an airplane by security and, as a result of the overly aggressive guards, you banged your head against a seat causing a concussion, broken nose, and your $2,000 laptop was destroyed. A few months later, your personal injury lawyer contacts the airline requesting compensation for your medical bills, emotional trauma, and lost wages from your physical injuries. It agrees to settle after the video of the incident goes viral. The settlement agreement stipulates that you receive $148,000 for medical expenses, pain and suffering and emotional trauma, and $2,000 for your computer. This settlement is 100% tax-free, for federal tax purposes, assuming you have not previously deducted any of the medical expenses.
I’m now going to change the facts a little to show how easy this is to turn into a taxable recovery. Assume the same facts as before, except that the settlement agreement now stipulates that you receive $130,000 for medical expenses, etc.; $10,000 for prejudgment interest; $2,000 for the computer; and $8,000 for the unrecoverable files on the computer. In this example, $18,000 of the settlement is taxable income. This income could have easily been avoided by allocating the interest and lost files to mental anguish; instead, you will have a tax bill on April 15th.