Taxes on Personal Injury Settlements: Tax Cuts and Jobs Act Rewrites the Rules
On December 22, 2017, the U.S. President signed the Tax Cuts and Jobs Act, more properly known as Public Law No. 115-97. This law makes sweeping changes to tax brackets and multiple changes to once-familiar deductions. As it turns out, though, the new tax code also has major impacts on plaintiffs awarded settlements or damages in personal injury cases.
In short, payments resulting from personal injury cases are not always tax-free. In fact, thanks to the new rules, plaintiffs may end up paying taxes on money that they never receive in the first place. The latest tax overhaul adds to the confusion of an already-complex taxing situation.
Here’s what plaintiffs need to know about the tax obligation associated with damages for personal injury cases, including provisions added under the latest tax overhaul:
- Only compensatory damages are eligible for tax-free treatment. Personal injury damages can be either compensatory or punitive. Only compensatory damages — funds awarded to make up for losses, such as medical payments, property damage, or reduced earning potential — qualify as tax-free. Punitive damages, intended to dissuade the defendant from similar action in the future, are taxed as plaintiff income.
- Emotional distress — and physical manifestations of emotional distress — are subject to taxes. Plaintiffs in personal injury cases sometimes receive awards for mental anguish or emotional distress. The IRS taxes these funds as income. Only damages awarded for physical injury or illness may escape taxation.
Of course, developing research attests to the close relationship between the body and the mind. Emotional distress can lead to physical symptoms, many of which mirror those of a physical illness. However, even if mental anguish leads to physical symptoms, and the plaintiff receives damages reflecting the condition, those funds remain taxable as income. The root cause of the illness or injury must be physical for damages to go untaxed.
- Damages awarded for emotional distress resulting from a physical injury may be tax-free. Here’s where the existing tax code gets tricky. Damages reflecting emotional distress that leads to physical illness are taxable income. However, damages reflecting emotional distress arising from physical illness may, in fact, be tax-free.
As attorney Robert W. Wood points out in Tax Notes, this leads to a difficult chicken-and-egg dance between collecting plaintiffs and the IRS. An unthoughtful worded case could lead the IRS to conclude that injuries are primarily emotional, and therefore fully taxable. On the flip side, a cleverly worded argument may place the primary injury in the physical realm, leading to tax-free damages. Note that in either case, the symptoms may be identical — under tax law, the real question is which came first: The physical or the mental injuries?
- Under the new tax law, plaintiffs cannot deduct taxable recovery payments including those that go to pay legal fees. This is perhaps the Tax Cuts and Job Act’s most striking change to taxation of personal injury damages. Plaintiffs with contingent-fee attorneys, who take payment as a percentage of the damages or settlement, are now responsible for taxes on the full value of the taxable pay-out.
Under previous law, the plaintiff could deduct legal fees taken out of damages. No longer. Say a plaintiff receives $1 million in damages for emotional distress. This is taxable income, according to the IRS. Now, say this plaintiff hired a contingent-fee attorney, who collects 50 percent of the damages. The plaintiff will walk away from the case with $500,000, but will pay taxes on the full $1 million.
- Legal fees associated with workplace claims may, in fact, be deductible. In some cases, plaintiffs can escape the tax burden of their legal fees. Claims against an employer may allow the plaintiff to deduct legal fees. If the defendant is not the employer, though, plaintiffs are on the hook for taxes on the full amount of damages or settlements, regardless of what their legal team takes home.
Given the shifting legal ground and the tax complexities associated with personal injury lawsuit damages, plaintiffs should work with tax professionals to ensure they meet all obligations under the law. Tax laws surrounding personal injury cases get terribly complicated.
Consider, for instance, that many cases involve damages with a mixture of taxable and non-taxable awards. For instance, a plaintiff may be awarded half the damages for emotional distress not arising from physical injury, and the other half for the injury itself. That plaintiff would have to pay taxes on the amount awarded as compensation for the emotional injury, but not funds deriving from the physical ailment.
If settlements aren’t written very carefully, with exact amounts attributed as compensation for exact conditions, the tax obligation becomes very murky indeed. As in cases of medical care themselves, these issues are best left to the professionals. Taxes on personal injury settlements in the wake of the Tax Cuts and Jobs Act are certainly not for the faint of heart.
Note: This analysis is not intended as legal advice.