Posted On July 17, 2015

Personal injury: IRS taxes emotional distress in settlement

Before a claimant in Nevada settles a claim for personal injuries from a car accident or receives settlement funds from any other kind of dispute, it might be best to consult with a tax attorney to determine how the recovery will be viewed by the IRS. Such settlements used to be generally free from income tax interference because it was determined that the settlement did not add any wealth that could be considered income. However, in the past few decades the IRS toughened the rules and started taxing the pain and suffering or emotional distress part of a settlement.

There is now a complicated maze of rules to confront when trying to determine the IRS’s position on the taxability of the settlement fund. As a general rule, if the compensation was for a physical injury it is a non-taxable event. If it was for emotional distress, it is taxable.

That rule makes it necessary to categorize parts of the settlement fund for future tax purposes. It has become necessary to do the tax analysis prior to accepting the settlement. This must be done by the person who was injured, especially where tax consequences may have an impact on the person’s financial status or ability to survive with the settlement amount.

With respect to other elements of the settlement, medical expenses are tax-free. Punitive damages are always taxable, according to IRS rules. The claimant will want to get professional tax advice to determine how legal fees are treated in the settlement with respect to various other complex issues that may be involved. The details should also be shared with one’s CPA or tax attorney for accurate and effective preparation of tax returns. A citizen of Nevada will face the above considerations whenever a disputed claim is settled and a compensatory recovery is scheduled to be received.

Source: forbes.com, “10 Things To Know About Taxes On Legal Settlements“, Robert W. Wood, July 6, 2015