John A. Davis, Attorney
It's 4:59 on a Friday, and you're ready to get out of the office. Your eyes glaze over the computer screen as you patiently wait to jump out of your chair. You blink. Boom – 5:00. You grab your coat, say the cordial goodbyes to your co-workers, and hop in your car.
The traffic's terrible, but no worries; you know the shortcut through the neighborhood up ahead. You start to smirk as you drive through, bypassing all the traffic. All of the sudden – SCREECH – BAM. It looks like another car had the same idea, but he failed to stop at the clearly visible stop sign. Your car is totaled...and you? You've been better.
A trip to the hospital has cost you thousands in medical bills. You've also missed work for the past month – a double whammy. Thankfully, you hired a competent personal injury attorney and are awarded a fair settlement to compensate your physical injury. As you begin to cut checks for your expenses, it hits you; is this money taxable? No, it likely is not. Allow me to explain... 26 U.S. Code § 61 states that "gross income" means all income from whatever source derived. This is important because gross income (minus deductions) is your taxable income. In other words, your paycheck from work? Taxable. You hit it big at the casino? Taxable. Even if you find $5.00 on the ground, it's technically taxable.
However, 26 U.S. Code § 104 allows an often overlooked exception to this general rule. It states that gross income shall not include the amount of any damages received on account of personal physical injuries or physical sickness. The critical word here is physical. In order for this exception to apply, the injury that you suffered must be a physical one. This means that other injuries, such as employment discrimination and defamation, would be taxable.
A physical injury is pretty much what you think – a punch to the face? Physical. A car runs over your foot? Physical. Someone poisons you? Physical. Consequently, if the settlement is to compensate you for expenses related to that physical injury, then it is non-taxable. This would include compensation for medical expenses (assuming you did not deduct them on your last return). The same goes for lost wages despite them being taxable if they were received in their normal capacity.
It should be noted that punitive damages are always taxable, regardless if they arose out of a physical injury, because their primary purpose is to punish the defendant. Another caveat to this non-taxable exception is that "emotional distress" is not considered a physical injury or sickness. Therefore, if you were to slide into a deep depression due to someone's non-physical wrongdoing, unfortunately your settlement would be taxable.
To recap, if you receive any settlement that compensates you for a physical injury or physical sickness, the portion of the settlement that is allocated to pain and suffering, medical expenses, and/or lost wages is non-taxable. This is valuable information to remember as people are physically injured every day!