Are Auto Accident Settlements Taxable?

In a car accident lawsuit, money received in a settlement for property damage, medical bills, physical pain and suffering, and emotional distress originating from a physical injury, are tax exempt. All other damages are taxable.

Auto accident settlements tend to include multiple parts. A portion of the settlement could be given to pay back medical bills, another could be given to pay back last wages, and yet another could simply be for vague pain and suffering. Each of these categories come together to make a final settlement. However, your total settlement can be decreased by the IRS if it is substantially made up of one of the taxable categories.

Before the question of taxes even arises, one may ask what the benefit of settling even is. Even though most victims gain their justice through settlement, there is a question of why not go straight to trial?

In fact, there are two main reasons for why settling is generally a more effective strategy than going to trial:

If you are injured, you likely want your money as fast as possible. The fastest way to get your money is through settlement. Going through a trial can take years. With mounting medical debt, and consistent creditors knocking at your door, you may wish to get your money sooner than later. Settling can help with that.

Even the strongest case in the world has a 1% chance of failure at trial. The truth of the matter is when you go to trial you are entrusting a jury, or judge, with your all of your damages.

They get to make the final decision on your damages. And while they should be unbiased, and while your attorney will attempt to make sure they are, nothing is completely for certain when you put your fate in the hands of six to twelve strangers. When you receive a settlement number from the insurance company, you can simply say yes, and receive the check.

To illustrate why settling can be a good thing, one might look at a practical example. For example, a case may have damages worth $100,000 if brought to trial. The problem with going to trial is that you may not be awarded that full amount. It may be reduced if the jury finds you partially negligent. The jury may agree that the other party is liable, but that the damages should be lower. That’s all assuming the jury agrees with you at all. It’s always possible that they may simply find, erroneous as it may be, the other party not liable, and you may receive nothing.

Before you even go to trial, your attorney will be in process of negotiating a settlement with the other side. While it is unlikely that the other side will offer the full amount, there is still a strong possibility that they will offer a substantial amount, so much so that a settlement may cover your most of your damages in itself. In fact, a settlement may cover all the money you owe to creditors.

For example, in this case, it is possible that the other side may offer $70,000, which, while less than the max amount possible, is going to be substantially less painful to get than the maximum $100,000 at trial. Instead of risking the $70,000 to go to trial, you may just accept that amount so that you have a guaranteed payout.

There are situations where settling is a bad idea. Generally, this occurs when you have a very secure case, and the opposing side is refusing to pay off any reasonable amount of their damages. Trial is good in those situations where the opposing side refuses to see the truth of the matter.

Sometimes insurance companies can be bureaucracies, and there are decisions made that don’t comport with the reality of the situation in front of them, causing this them to refuse to provide settlement money that they would almost definitely have to provide in court. In these situations, it may be best to go to trial.

Car accident settlements are payments meant to make you whole. You total settlement will just be the collection of all of your damages.

Generally, there are two large categories of damages. Specific damages, which are meant to reimburse you for money you had to spend to make yourself whole again, and general damages, which is money given to you as justice for intangible injuries to your person.

The likely damages are listed below:

Property and Vehicular Damage

You can expect financial compensation for the cost of repairs to your vehicle, or, if totaled, the market value of your vehicle. Other property damage can also be reimbursed.

Medical Care

Any related medical care, including surgery, emergency room visits and over the counter medication can be reimbursed through your settlement damages. Furthermore, it is extremely common to receive money for estimated future medical costs that you may receive in the case of long-term injury or permanent disability.

Lost Income

Any lost income from your inability to work can be reimbursed. This could be a reimbursement based on your salary for necessary time off, or future wages lost in the case of permanent disability.

Pain and Suffering

Continual pain and suffering is something that can haunt a person after a car crash. You can receive compensation to try and provide some justice for the pain caused by the injuries.

Emotional Distress

Emotional Scars can also occur in car crashes. Again, this damage does not necessarily connect to a specific medical or repair. Rather the law is attempting to provide you financial justice for your continual distress.

Punitive Damages

Punitive damages are rarely awarded in car accident cases. By their nature punitive damages are only awarded when the aggressor was malicious in causing damages or committed gross negligence. Someone purposefully ramming your property with their car would create an opportunity for punitive damages.

The answer is that portions of the auto accident settlement are taxable by the IRS, while others are tax exempt. Generally, there is some sense to these classifications by the IRS, but not always.

Vehicular and Property Damage

As a specific damage, the IRS knows that you need this money to pay back creditors, rather than enriching yourself. Therefore, the IRS allows this as an exception.

Medical Care

Like above, this payment will get turned around and get paid to your medical bills. The IRS has mercy, and lets you keep all the cash to pay back the creditors as best you can.

Pain and Suffering

Generally, physical pain and suffering is tax exempt, even though it is not going to pay back something tangible. The IRS allows this as a special exemption.

Lost Income

The logic for why lost income is taxable is sound. If you had received your income in the first place, without injury, it would have been taxed. In this fashion, both you and the IRS benefit from you winning your lawsuit.

Punitive Damages

The IRS also taxes punitive damages, as they do not actually provide compensation for anything, but rather exist to punish the offender. You just happen to be a beneficiary of such damages.

Emotional Distress

The answer to whether emotional distress damages are taxable requires a deeper inquiry into how the distress came into being. If the emotional distress originated from a physical injury, it is not taxable. However, if the emotional distress originated from no physical injury, then it is taxable.

For example, if you get a physical injury that permanently disables you, and thereby become depressed, your damages will not be taxed. If you did not get any injuries in a car accident, but develop an anxiety disorder from the car crash, the IRS could tax you.

Unfortunately, these categories still apply if you win your lawsuit in Court.

The tax code controls what damages are taxable by the IRS. The applicable regulation that controls is 26 C.F.R. §1.104-1. It states that:

(c) Damages received on account of personal physical injuries or physical sickness—(1) In general. Section 104(a)(2) excludes from gross income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. Emotional distress is not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2). Section 104(a)(2) also excludes damages not in excess of the amount paid for medical care (described in section 213(d)(1)(A) or (B)) for emotional distress.

This section notes that the applicable settlement types noted above are exempt from income tax. However, the tax code explicitly excludes punitive damages, and emotional distress disconnected from physical injury from the exception. Because taxes for lost income are not included in this exception, they are also taxable as normal income.

It is unlikely you can legitimately avoid paying taxes on the taxable categories. However, there are certain things you can do to make sure that you pay the least amount of taxes possible.

Have your written settlement agreement organize your settlement amounts into the above categories

The best way to prove to the IRS which damages you receive are exempt are which are not is to simply organize the money you receive into categories in your written settlement agreement. Having this written settlement agreement organized this way can help you out in the case of an IRS inquiry (which may happen if you have a lot of damages), but it can also assist you when you file your taxes and want to know what amount is tax exempt.

Agree to yearly payment plans for certain long term taxable damages

Massive amounts of future taxable damages can push you into a higher tax bracket for the year. This is common with future wage loss damages, which, if paid out in one swoop, could be upward of millions of dollars. Agreeing to a yearly payment plan could work in making sure that you do not get bumped up to another tax bracket.

Taxes are inevitable, even in settlement agreements. Still, knowing what categories of damages can be helpful in determining your final settlement costs, as well as what to expect when bringing your damages home. Even with this knowledge you will want to work with an experienced attorney to assist you with your settlement amounts.