If you have received a personal injury settlement in Massachusetts, you may be wondering whether you will owe taxes on that money. After all, a significant settlement could bump you into a higher tax bracket or leave you with a hefty bill come tax season. The good news is that in most cases, personal injury settlements are not taxable under either federal or Massachusetts state law. However, there are some important exceptions to keep in mind.
Personal Injury Settlements are Generally Not Taxable Income
The IRS states that money received as part of a settlement or judgment for personal physical injuries or physical sickness is not considered taxable income. This rule applies whether you settled the case before filing a lawsuit in court or received a judgment after a jury trial. The reasoning is that this money is meant to compensate you for your injuries and make you "whole" again -- it is not income in the traditional sense.
This tax exemption applies to compensation for things like:
- Medical bills
- Lost wages due to missed work
- Emotional distress stemming from your physical injuries
- Pain and suffering
- Attorney fees (more on this later)
So, in a typical personal injury case, such as a car accident settlement, you likely will not owe any taxes on the money you receive. However, as with many legal matters, there are some critical caveats and exceptions.
Exception #1: Interest is Taxable
If your settlement includes interest, that portion will be taxable as "interest income" under federal and Massachusetts state law. This scenario most often arises when there is a significant delay between the injury and the payment of the settlement, such as when a case goes to trial.
For example, say you are awarded $100,000 in damages plus $10,000 in interest. You would not pay taxes on the $100,000, but the $10,000 in interest would be taxable income that must be reported on your tax returns.
Exception #2: Emotional Distress Damages Not from Physical Injury are Taxable
Another major exception is when a settlement includes compensation for emotional distress that did not stem from your physical injuries. While emotional distress damages that flow from a physical injury are tax-exempt, emotional distress on its own is not considered a physical injury or sickness.
So, if part of your settlement is specifically allocated for emotional distress and it was not a result of your physical injuries, that portion would be taxable income. If you are claiming damages for emotional distress in your personal injury case, it is crucial that your attorney clearly show how it resulted from your physical injuries to avoid taxation.
What About My Attorney Fees?
In most personal injury cases, your attorney will be paid a percentage of your total settlement amount as a contingency fee. For tax purposes, it is as if that money was paid to you, and you then paid your attorney -- even if the money goes directly from the defendant to your lawyer.
So, while your total settlement may not be taxable income to you if part of it is taxable (like interest or separate emotional distress damages), then the corresponding portion of your attorney fees would also be considered taxable income. However, those legal fees would also likely be deductible as a miscellaneous itemized deduction on your federal tax return, subject to the 2% of adjusted gross income limitation.
To avoid any confusion, your personal injury attorney should provide a detailed breakdown of your settlement showing what amounts were paid for your physical injuries, emotional distress stemming from those injuries, interest, and attorney fees. Having a clear record will be vital if any questions arise down the line.
Planning for Your Tax Liability
The bottom line is that while the majority of personal injury settlements are not taxable, it is still wise to consider the tax implications during settlement negotiations. Having your attorney specify that the money is compensation for your physical injuries can help avoid an unexpected tax hit. And if your settlement will include taxable interest or emotional distress damages, planning for that tax liability is crucial.
At Altman Nussbaum Shunnarah, we have extensive experience structuring settlements to minimize our clients' tax burden while maximizing their financial recovery. If you have been injured, contact us for a free consultation to discuss your case and how we can help you navigate the legal process from start to finish -- including handling any tax issues that may arise.