When someone receives a settlement in a personal injury case, they might assume that the total compensation is theirs to keep. In some cases, it may amount to hundreds of thousands of dollars, or even millions, in damages. It’s not money they received from working a job, and in many cases, it’s money that repays out-of-pocket expenses they either have already incurred or will. But that’s an assumption that could result in problems with tax agencies. Here’s what you need to know.

Do the Federal or State Governments Tax Personal Injury Settlements?

This is not a straightforward yes-or-no question. In most cases, no, the federal government won’t tax a personal injury settlement, as long as a physical injury (which includes illnesses resulting from being exposed to germs or something toxic) was involved. Suppose someone was not physically injured, but suffered something like post-traumatic stress disorder (PTSD) or emotional pain and suffering (for example, someone who files for emotional distress from employment discrimination wouldn’t necessarily have a physical injury). In that case, they might receive a settlement, but that settlement will be taxed.

States don’t usually tax personal injury settlements either, generally following the federal government’s approach in terms of physical injury or illness. This is because these types of compensation are considered to benefit the claimant for a number of things, including lost wages and medical bills.

However, there are a few exceptions to this overall policy.

Punitive damages. Punitive damages are taxable. That’s because this is a separate type of compensation that is less focused on the financial cost of the injury and more focused on punishing the liable party for what might have been extreme negligence. It’s not a repayment of out-of-pocket expenses, so it’s viewed as income.

Interest paid on the judgment. Often a judgment is awarded, but then the defendant appeals the case and it lasts several more months. In most states, the court would have decreed that the settlement be paid interest from the time it was first awarded. So if someone was awarded a settlement, but the appeals lasted another 18 months, interest would accrue for those 18 months. That interest is taxable.

Breach of contract. If your injury was caused by a breach of contract and that’s the foundation of your lawsuit, any damages awarded will be taxed.

Do I Need to Report a Settlement as Income?

If your case falls into the category of not being taxable (as described above), there’s nothing you have to do. If your settlement is taxable, you should receive a form 1099-MISC which you use to report the income on your tax return. On your tax return, use the “other income” box.

If there are questions about whether or not your settlement is partially or fully taxable, it’s a good idea to talk with an experienced personal injury attorney.

What About Workers’ Compensation Payments?

The federal government will not tax workers’ compensation payments as long as those payments were made through a workers’ compensation act. In Delaware, there is a workers’ compensation act in place, so someone receiving payments here would not be taxed.

However, just as with personal injury settlements, there are some exceptions for workers’ compensation payments. Often people who receive workers’ compensation also receive disability benefits of some type, including Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI). When someone receives both workers’ compensation and a disability benefit, and together those are more than 80% of the person’s full-time salary, the government would lessen the amount of one of the benefits to get the person to the 80% point. The amount of the reduction is called the workers’ compensation offset, which can be taxable if the person receives regular payments.

Lump-sum workers’ compensation payments can be taxable if they exceed 80% of the person’s salary as well.

What Else Should I Know About My Lawsuit Settlement?

There are several things to keep in mind.

There are two ways the settlement will be paid to you. Either you’ll receive a lump-sum payment (the whole amount at once, or large chunks at predetermined times), or you’ll have a payment schedule. At times, the settlement might use both of these approaches.

When it comes to payment schedules, there are two types: Decreasing and increasing. In a decreasing schedule, the amount paid is reduced over time, which is especially useful for people whose medical costs are highest at the beginning of the settlement phase. An increasing schedule does the opposite and is valuable for people whose medical costs will increase over time.

Lump-sum payments can be helpful if you want to invest them to earn returns, but those returns would be taxable. Not taking a lump-sum settlement means the total could be worth less if there’s an inflationary period.

Because compensation can be handled in a variety or combination of ways, each with its own set of pros and cons, having an experienced attorney to advise you is recommended.

What Should I Do if I Received a Personal Injury Settlement and Might Have to Pay Taxes?

Call Hudson, Castle & Inkell at 302-428-8800 to set up a free case evaluation. Our experienced, knowledgeable attorneys can guide you through what you need to know about your settlement and how to make sure you don’t run afoul of the tax agencies. We can also help you sort out the options for how to receive the settlement payments, the pros and cons of each, and which best fits your unique situation.