When an individual recovers a monetary award from a personal injury settlement, verdict or wrongful death claim, a common and critical question arises: Are settlement proceeds taxable? Under federal law, the answer depends on the nature of the damages recovered, not simply whether the funds came from a settlement or trial. Understanding how the Internal Revenue Code treats different categories of damages may help plaintiffs avoid unexpected tax liabilities and plan appropriately after recovery.
Tax Exclusions for Physical Injuries or Sickness
Generally, compensatory damages received on account of personal physical injuries or physical sickness are excluded from gross income under Internal Revenue Code § 104(a)(2). This includes:
- Medical expenses
- Pain and suffering
- Emotional distress directly tied to a physical injury
- Lost wages attributable to a physical injury
Note: This exclusion applies only if the damages arise from a physical injury or physical illness. Emotional distress alone, without an underlying physical injury, does not qualify for the exclusion.
Taxable Components of Settlements
Certain components of a personal injury or wrongful death recovery may be taxable.
- Punitive damages -almost always taxable, even with a physical injury or wrongful death claim
- Interest on a judgment or settlement—including pre- or post-judgment interest
- Emotional distress damages not tied to physical injury
- Reimbursement of previously deducted medical expenses
Federal Tax Treatment in Wrongful Death Cases
In wrongful death cases, federal tax treatment generally follows the same principles. Compensatory damages paid to survivors for the decedent’s physical injuries or death are typically excluded from income, while punitive damages and interest remain taxable.
Importantly, how the settlement agreement or verdict allocates damages among categories may significantly impact tax consequences. Courts and the Internal Revenue Service often look to the underlying facts and the express terms of settlement agreements when determining taxability.
Planning Ahead
Settlement taxation can be complex. Plaintiffs should work closely with legal and tax advisors before finalizing a settlement or accepting a verdict payment. Proper structuring, clear damage allocations, and advance tax planning may reduce exposure to unexpected federal taxes and preserve more of the recovery intended to compensate for injury or loss.
A knowledgeable attorney may help ensure that settlement proceeds are handled in a way that aligns with legal rights and tax efficiency.
Michael Salad is an attorney in Cooper Levenson’s Business & Tax practice group. He concentrates his practice on estate and asset protection planning, probate and trust administration, special needs planning, business transactions, mergers and acquisitions and tax matters. Michael holds an LL.M. in Estate Planning and Elder Law. Michael is licensed to practice law in Florida, New Jersey, New York, Pennsylvania, Maryland, Connecticut, Georgia, Massachusetts, Alabama, Arizona, Virginia and the District of Columbia. Michael may be reached at (954) 889-1850 or via e-mail at msalad@cooperlevenson.com.
The content of this post should not be construed as legal advice. You should consult a lawyer concerning your particular situation and any specific legal question you may have.