TL;DR: Monsees & Mayer – Taxes on Settlements
Most personal injury settlements are not taxable, but certain claims—like backpay, emotional distress not arising out of physical injury, and punitive damages—may be taxable. IRS rules affecting the taxation of personal injury settlements can be complex. For that reason it is important you consult with a tax professional before finalizing any personal injury settlement.
When clients ask, “Do I have to pay taxes on my settlements?” the answer often depends on what the money represents. According to IRS rules, settlement taxes are determined by the nature of the claim—not just the amount you receive.
Are Personal Injury Settlements Taxable?
In most cases, no. According to the IRS, compensation received for physical injuries or physical sickness is not considered taxable income.
When Are Settlements Taxable?
Taxes apply to non-physical damages or portions of your award tied to economic recovery, such as:
1. Certain Employment Claims
If your settlement includes backpay or future lost income, that portion may be treated like income—subject to both federal and state income tax. Be sure to consult with a tax professional and find out if you need a 1099-MISC or W-2.
2. Punitive Damages
Punitive damages—awarded to punish a defendant and deter others from similar wrongdoing (rather than compensate the victim)—are likely included in gross income.
3. Emotional Distress (Non-Physical)
If you receive compensation for emotional distress that did not result from physical injury, it may be included in gross income. For example, a sexual harassment settlement without a physical injury component may be taxed. However, emotional suffering that stems from a physical injury (such as PTSD after a crash) would likely be excluded from gross income.
“Personal injury cases involving emotional distress damages not accompanied by physical injury must be handled carefully. We encourage our clients to consult with a tax professional before any settlement is finalized,” says Reed Martens of Monsees & Mayer.
Allocating Damages in a Settlement Agreement
The language in your settlement agreement matters tremendously. If audited, the IRS may look to the language of the settlement agreement to determine whether such amounts are included in gross income (e.g., $80,000 to medical expenses, $20,000 to lost wages). Without specific allocations, the IRS may assume the entire amount is taxable.
“We generally work with our clients’ tax professionals to meticulously structure settlement language. This approach protects our clients from unnecessary tax exposure,” says Chip Lee, who handles personal injury settlements in Missouri and Arkansas.
What About Interest?
If your case is settled after trial or takes years to resolve, the court may award pre- or post-judgment interest on top of damages. This is yet another potential complication with personal injury settlements that necessitates consultation with a tax professional to make sure your best interests are accounted for.
Missouri allows pre-judgment interest on certain claims (see e.g., RSMo § 408.040), and similar statutes apply in Kansas and Arkansas.
IRS Forms to Expect
Depending on your award, you may receive:
- 1099– For taxable damages like punitive damages.
- W-2 – If lost wages were paid.
- No form – For non-taxable personal injury settlements
Keep in mind that the IRS can still audit large settlements, even when no forms are issued.
Reporting Settlement Income
If any portion of your settlement is taxable, you must report it on your tax return. We strongly recommend working with a tax professional familiar with litigation awards to ensure compliance.
FAQ
Do I pay taxes on a personal injury settlement?
Generally, no. If the settlement compensates for physical injury or physical sickness, it’s excluded from gross income. However, certain employment-related claims and punitive damages are likely included in gross income.
Are emotional distress damages taxable?
Maybe. It likely depends on whether the emotional distress arises from physical injury.
