Some parts of a personal injury settlement are taxable in California, while others are not. If you’re injured in a personal injury accident, you need to understand the tax rules.
Our experienced San Bernardino personal injury lawyers at LA Century Law explain whether personal injury settlements are taxable in California.
The Short Answer: Are Personal Injury Settlements Taxable?
No, mostly.
- Most parts of a personal injury settlement are not taxable in California.
- Both U.S. federal and state tax laws exclude personal injury settlements from taxation.
- The exemption applies to compensatory damages, such as medical bills, lost income, and pain and suffering.
- Lost income is not taxed, as long as it’s in a personal injury settlement and not a different type of lawsuit, like wrongful termination.
- Punitive damages are taxed, even if they are part of personal injury compensation.
A lawyer can provide personalized advice about what parts of your personal injury settlement will be taxed.
What the IRS Says About Personal Injury Settlement Taxes
The IRS begins by stating that income from any source is taxable. However, there are exceptions. Personal injury compensation is one exception.
26 U.S.C. § 104 is the IRS rule that states that money paid on account of personal physical injury or sickness is exempt from tax.
What California Says About Personal Injury Settlement Taxes
Generally, California bases its income tax on federal adjusted gross income (AGI). Federal AGI is the starting point for determining California tax liability.
However, federal and California tax rates differ, and there are additional differences for deductions and credits. It’s called being a non-conforming state because the California deductions don’t conform exactly to federal rules.
For personal injury, though, the tax rules are the same federally and in California.
In California, the Franchise Tax Board (FTB) administers taxes.
Which Types of Compensation Are Tax-Free in California?
Types of compensation that are tax-free in a California personal injury claim are:
- Medical bills
- Medical supplies
- Physical therapy
- Personal care
- Lost income
- Disability
- Pain and suffering
- Emotional anguish
- Property damage
These categories of damages are compensatory. They compensate the person for losses resulting from personal injury. If the funds were taxed, the person wouldn’t truly be made whole.
Which Parts of Your Settlement May Be Taxable?
Parts of a personal injury settlement that may be taxable are:
- Punitive damages
- Interest
- Amounts previously deducted as medical expenses
Emotional distress compensation is only taxable if it’s not the result of an underlying physical injury. Effectively, in personal injury cases, emotional distress compensation won’t be taxed.
Are lost wages from personal injury settlements taxable?
There is some confusion about whether lost income is taxable in a personal injury settlement. Other sources online will tell you that lost wages are taxable, but that’s not true if the lost wages are paid as part of a personal injury claim.
When wages are paid for employment discrimination or wrongful termination, then they are taxed. But if it’s part of a personal injury lawsuit, it’s not taxed.
See: Rev. Rul. 85-97 (The entire amount, including lost wages, is excluded from gross income).
Damages – Personal Injury – Instruction to the Jury on Federal Income Tax.
Compare: Rev. Rul. 96-65 (Counting lost wages as gross income in an employment discrimination claim).
There may even be a jury instruction explaining taxation so they don’t inflate an award to account for it. A lawyer can help you ensure that lost wages are calculated properly.
Can I just say it’s not for lost wages?
Given the confusion, it might seem easy enough to just say that your personal injury award is for something other than lost wages. But depending on your personal circumstances, the designation may be important. For example, a personal injury settlement may include an agreement regarding work credits. An example of this is discussed in Rev. Rul. 61-1, where the injury occurred in the course of employment, and the personal injury settlement included time-lost-work credit.
Are Punitive Damages Taxable in California Personal Injury Cases?
Yes. Punitive damages are taxable in a California personal injury case. That’s because they don’t compensate for a specific loss. Instead, they punish the defendant for extremely offensive conduct.
What Happens If Your Settlement Includes Lost Wages or Emotional Distress?
If your personal injury settlement includes lost wages or emotional distress, rest assured that these amounts are not subject to tax. The IRS will look beyond what the funds are called to their true purpose. For example, you can’t hide punitive damages from taxation by calling it emotional distress. But amounts paid for lost wages and emotional distress arising from personal injury are exempt from taxation in California.
Does it matter if you settle your case or go to trial?
No. For the purposes of taxation, it doesn’t matter if you settle a personal injury case or go to trial. When you settle the case, you may have a say in how your award is designated. But overall, tax rules are the same for personal injury settlements and jury verdicts.
Should You Talk to a Tax Professional Before Settling Your Claim?
Yes. You should absolutely talk to a tax professional before settling a personal injury claim. It’s important to understand the tax implications of your award so you are prepared. You don’t want to be surprised by an unexpected tax bill.
Plus, there are steps you can take to minimize your tax liability and maximize your award. Tax liability is one consideration. How you structure your claim can significantly impact the outcome of your case. A knowledgeable attorney knows how to structure a claim for your best interests.
How a San Bernardino Personal Injury Attorney Can Help Structure Your Settlement
When you’re hurt in a personal injury accident, there are many things to consider. One crucial factor is whether personal injury lawsuit settlements are taxable in California. A San Bernardino personal injury attorney can negotiate your award with tax implications in mind. Your lawyer can explain things so that you have confidence in your case.
LA Century Law is a team of experienced, accomplished personal injury attorneys serving San Bernardino and the surrounding areas. We can assist you at any stage of your case. Call or message us now.
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