When you get injured in an auto accident, you need to make sure you receive as much compensation as possible. You also need to make sure you keep as much compensation as possible. That’s right, we’re talking about taxes. So, are auto insurance settlements taxable?
A Portion of Your Auto Accident Settlement Could Be Taxable
If you receive a settlement for an auto accident, a portion of your settlement could be taxable. The Internal Revenue Service (IRS) has published a guide on the taxability of settlements, and it covers the basics pretty well. Here are some of the highlights:
1. Compensation for Physical Injuries is Not Taxable (In Most Cases)
Compensation for physical injuries from an auto accident is not taxable in most cases. As the IRS explains: “If you receive[d] a settlement for personal physical injuries [from an auto accident] . . . and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income.”
When the IRS refers to a settlement for “personal physical injuries,” it is referring to the potion of your settlement that covers your medical expenses from the accident (both current and future). Since this portion of your settlement is simply intended to make you whole, it is not considered income under the Internal Revenue Code.
However, if you deducted medical expenses from the accident on last year’s income tax return, then you need to claim this portion of your settlement so that you don’t get the deduction and get tax-free compensation. In the words of the IRS, “you must include in income that portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit.”
2. The Portion of an Auto Accident Settlement that Covers Lost Income is Not Taxable
If your auto accident settlement includes compensation for loss of income, then this portion of your settlement is not taxable. The IRS only taxes compensation for loss of income awarded in employment-related lawsuits. Since an auto accident claim is not an employment-related lawsuit, this portion of your settlement is not subject to income tax under federal law—even though your income would have been taxed had you earned it through employment.
3. Compensation You Receive for Emotional Distress or Mental Anguish in an Auto Accident Settlement is Not Taxable (In Most Cases)
Under federal law, any compensation you receive for emotional distress or mental anguish in an auto accident settlement is not taxable—in most cases. The IRS states, “The proceeds you receive for emotional distress or mental anguish originating from a personal physical injury . . . are treated the same as proceeds received for [p]ersonal physical injuries . . . .”
In other words, the general rule is that compensation for emotional distress or mental anguish resulting from an auto accident isn’t taxable; but this compensation can be taxable to the extent that it covers medical bills you have already paid (and deducted on your federal tax returns). If you haven’t deducted any medical expenses since the date of your accident, then you don’t have to worry about any potential tax consequences of your auto accident settlement. However, if you have deducted medical expenses, you will need to review your deductions and determine what percentage relate to expenses that are covered by your settlement.
“Emotional distress” and “mental anguish” cover all of the non-financial effects of auto accident injuries. This includes, but is not limited to:
- Anxiety and depression
- Challenges of coping with permanent scarring and disfigurement (including shame and humiliation)
- Emotional trauma
- Grief, worry, fear, and anguish
- Post-traumatic stress
- Loss of companionship and consortium
- Loss of enjoyment of life
- Loss of services, society, and support
4. Compensation for the Damage to Your Vehicle Generally Isn’t Taxable
Any compensation you receive for the damage to your vehicle isn’t taxable—as long as it does not exceed your “adjusted basis” in the vehicle. In most cases, this is simply what you paid. Since most cars depreciate over time, it is unlikely (though not impossible) that the portion of your settlement that covers your vehicle is greater your adjusted basis and triggers income tax liability.
5. Punitive Damages Are Subject to Federal Income Tax
Here’s where the general rule reverses. While compensatory damages generally are not subject to federal income taxation (subject to certain exceptions, including those discussed above), punitive damages generally are taxed under federal law. The IRS makes this clear: “Punitive damages are taxable and should be reported as ‘Other Income’ on line 21 of Form 1040, Schedule 1, even if the punitive damages were received in a settlement for personal physical injuries . . . .”
So, to the extent that your auto accident settlement includes a portion specified as punitive damages, you will need to report this portion of your settlement as taxable income on your federal income tax return.
Your State’s Tax Laws May Impose Different Requirements
To be clear, the discussion above covers federal income tax liability only. State tax laws may impose different requirements. While most state tax laws generally follow the Internal Revenue Code in most cases, there are exceptions, and you do not want to inadvertently underpay state income tax on your auto accident settlement.
How Can You Minimize Your Income Tax Liability from an Auto Accident Settlement?
With all of this in mind, what can you do to minimize your income tax liability from an auto accident settlement. To an extent, you can structure your settlement so that the tax laws work in your favor. For example, if you have already deducted medical expenses from the accident, you may be able to specify that your settlement covers other types of non-taxable losses.
However, when attempting to minimize your income tax liability, you need to be careful. There are legitimate classifications of settlement compensation, and then there is income tax fraud. If you improperly classify settlement proceeds as non-taxable income, you could face unwanted scrutiny from the IRS and/or your state’s tax authority. This is yet another reason to hire an experienced lawyer through CarAccidentSource.com to help with your auto accident settlement.