Are Personal Injury Settlements Taxable in California?
It surprises many plaintiffs to discover that winning a personal injury lawsuit or accepting an insurance settlement offer doesn’t exactly mean “case closed.” There is still the matter of receiving the settlement or judgment check from the defendant…and then dealing with the extra money come tax season. The State of California and the federal Internal Revenue Service (IRS) may impose taxes on some or all of a personal injury settlement, depending on the circumstances. Here’s what you need to know about settlement taxation in California.
Federal Settlement Taxes
Most personal injury settlements include payments for different types of damages. For example, a car accident settlement may involve recovery for medical bills, lost wages, property damage, emotional distress, and attorney’s fees. The federal government will tax some, but not all, types of damages in an injury settlement. According to the IRS’s Settlements – Taxability guide, you may need to pay taxes on the following damages as a plaintiff:
- Medical expenses. If you paid for medical costs for more than one year. If you added an itemized deduction to your taxes for medical costs in previous years, you will owe taxes on your medical compensation. You will need to pay pro rata taxes on the amount of medical expenses you paid each year you listed them as deductions. If you did not take an itemized deduction for medical costs in previous years, the full amount of your medical settlement is tax-free.
- Non-economic damages. Damages for emotional distress and mental anguish are non-taxable, unless you received these damages for a reason other than from a physical injury or physical sickness (for example, if you collected these damages for witnessing someone else’s injury). The amount of damages you must pay taxes on will not include amounts you paid for related medical expenses (therapy, etc.) not previously deducted or previously deducted medical expenses that did not give you a tax benefit.
- Lost wages. You will need to pay taxes on a lost wages damage award. Since you would have had to pay Social Security and Medicare taxes on these wages if you’d been able to work, you will have to pay the taxes on your lost wage settlement amount. The taxes you’ll have to pay depend on the taxes you typically pay on your income or from business ownership.
- Property damages. You will not need to pay taxes on settlements that repay you for lost value of property that are less than the adjusted basis of your property. You will, however, need to adjust your basis in the property by the amount you receive in the settlement. If the settlement amount exceeds the property’s adjusted basis, you will need to pay taxes on the excess as you would regular income.
- Punitive damages and interest. The IRS mandates all claimants pay taxes on punitive damage awards, taxed as “Other Income.” Punitive damages are additional awards to punish the defendant. You will need to pay taxes on any punitive damages, as well as interest you receive on any settlement.
The majority of personal injury settlements are tax-free. This means that unless you qualify for an exception, you will not need to pay taxes on your settlement check as you would regular income. The State of California does not impose any additional taxes on top of those from the IRS. Only a tax expert can give you 100% accurate details about which taxes you will and will not have to pay after receiving a personal injury settlement award in California. Seek professional help during tax time to make sure you obey the rules. Otherwise, you could end up paying tax penalties and fees.
