Fighting for your injury settlement might have been the hard part, but that doesn’t mean your struggle is over. Once tax season comes around, do you know how to report your settlement to the Internal Revenue Service (IRS)? Do you have to report it at all? Making a mistake on your taxes after receiving a settlement could result in serious tax penalties and other consequences. The government has laws about whether settlements are taxable. Here’s what you need to know as a claimant in West Virginia.
You’ll find the federal statute on whether settlements are taxable in the U.S. Code, Title 26, Section 104(a). According to this law, the government will not tax damages a claimant receives in a personal injury settlement. This includes both settlement agreement damages and recovery via a lawsuit, as well as lump sum and periodic payments. The statute covers general and special damages, but not punitive damages. This means that while you may have to pay tax on a punitive damage award, the following are tax-free:
Punitive damages are those which the courts award in addition to other damages as a way to punish the defendant for particularly negligent or malicious actions. West Virginia currently has no cap on punitive damages in cases that arose before June 8, 2015. Cases after this date are subject to the state’s cap of $500,000 or four times the amount of compensatory damages (whichever is greater). The IRS taxes punitive damages, meaning you must list it as income on your taxes.
Note that the federal government will also tax the portion of your settlement that covers your lost wages or missed time at work because of an accident. Since you would have had to pay taxes on your income were it not for the accident, the IRS believes you should have to pay taxes on them in a settlement. You can request for the division of your settlement receipt into taxable and non-taxable damages for the IRS’s benefit.
Whether you have to pay taxes on settlement income depends upon your situation and the type of damages you received. Since so many different types of damages, from attorney’s fees to emotional distress, can exist within a single settlement, a yes or no answer is impossible. Instead, you must look at the type of damages in your settlement to determine if they’re taxable or tax-free. A tax professional or a personal injury attorney can help with these issues.
In general, the full amount of your settlement will be non-taxable if it consists only of recovery for physical sickness or injuries, and if you did not take an itemized deduction for injury-related medical expenses in prior years. If this is the case, you will not list the proceeds from your settlement in your income when filing. If, however, you deducted medical expenses relating to your accident in prior years, you will have to pay taxes. You cannot list the expenses as a deduction and keep your settlement tax-free.
You may also have to list your settlement (or portions of it) as earned income if you received payment for emotional distress or mental anguish that didn’t originate from injury or sickness, payment for lost wages or lost profits from a business, interest from a settlement, or punitive damages. Learn more about the federal taxation of settlements from the IRS’s website or talk to an accounting professional or attorney for assistance.