Is a Car Accident Settlement Taxable? What the IRS Says

The federal tax code excludes from gross income the amount of any damages, other than punitive damages, received on account of personal physical injuries or physical sickness, whether by lawsuit or settlement and whether as a lump sum or periodic payments. A car accident that caused a physical injury produces a settlement within that exclusion, and the exclusion extends to every category of compensatory damages that flows from the physical injury: the medical expenses, the pain and suffering, the loss of enjoyment of life, the emotional distress caused by the injury, and the lost wages.

The lost wages point surprises people, because wages are ordinarily taxable. But lost wages recovered as damages for a physical injury are excluded, because they are received on account of the injury; the IRS and the courts have been consistent on this. The exclusion is why structured settlements are attractive: the periodic payments, including the growth inside the annuity that produces them, are excluded as damages for the physical injury.

The exclusion does not depend on how the settlement is labeled. A settlement that does not allocate among categories is treated as compensatory damages for the physical injury if that is what the claim was, though an allocation in the agreement helps and is followed by the IRS when it reflects the claim's reality.

Punitive damages are taxable income in every case, even when awarded in a physical injury case, because they punish the defendant rather than compensate the injury; the exception is a narrow one for certain wrongful death cases in states where only punitive damages are available. A settlement that includes a punitive component, or a judgment with a punitive award, has a taxable portion, and the allocation matters.

Interest is taxable. A judgment that accrues interest from the date of the verdict or the date of the injury, under state law, produces taxable interest income, reported separately. A settlement that includes an interest component, or a structured settlement payment that is characterized as interest rather than damages, is taxable to that extent; properly structured settlements avoid the characterization.

Emotional distress damages are taxable unless they arise from a physical injury or physical sickness. Distress from a crash that caused a physical injury is excluded as part of the injury damages. Distress from a crash that caused no physical injury, a claim for fright or anxiety alone, is taxable, except to the extent of medical expenses paid for its treatment. The line between physical injury and emotional distress is where most disputes with the IRS about injury settlements arise.

Suppose your claim for a back injury settled for $150,000, allocated in the agreement as $40,000 for medical expenses, $25,000 for lost wages and $85,000 for pain and suffering, with no punitive component and no interest. The entire $150,000 is excluded from income; none of it is reported. The attorney's fee and the liens come out of it, but they do not change the tax result because the whole amount is excluded.

Now suppose you had deducted $6,000 of the crash-related medical expenses on the prior year's return as an itemized deduction, because they exceeded the threshold that year. The settlement reimburses those expenses, and $6,000 must be included as income in the year the settlement is received, under the tax benefit rule, to the extent the deduction actually reduced your tax.

Now suppose instead the case went to trial, the jury awarded $150,000 compensatory and $50,000 punitive, and the judgment accrued $9,000 in interest before it was paid. The $150,000 is excluded; the $50,000 punitive and the $9,000 interest are taxable income, and the attorney's fee attributable to the taxable portion is, under current federal law, generally not deductible for an individual, which means tax is owed on the gross taxable amount. All figures are hypothetical, and a tax professional reviews any settlement with taxable components.

The tax result is largely fixed by the nature of the claim, but the agreement and the records affect it.

• Have the settlement agreement allocate the amount among categories, medical expenses, lost wages, pain and suffering, and identify any punitive or interest component, reflecting the claim's actual substance.
• Keep the agreement, the closing statement and the records of the injury and treatment; if the IRS questions the exclusion, the physical injury is proven from them.
• Check prior years' returns for any deduction of crash-related medical expenses; the reimbursed portion is income to the extent the deduction reduced tax.
• Ask whether the defendant will issue a Form 1099; one is not required for excluded damages, and an erroneous 1099 is corrected with the payer or explained on the return.
• For a structured settlement, confirm the annuity is set up so that the payments are damages for the injury, not interest.
• Consult a tax professional for any settlement with punitive damages, interest, an emotional distress claim without physical injury, or a prior medical deduction.
• Do not rely on the insurer or the defendant for tax guidance; their interest is in closing the file.

Most states with an income tax follow the federal exclusion for physical injury damages, because their tax codes start from federal adjusted gross income, so a settlement excluded federally is excluded at the state level. A few states have their own provisions, and a settlement received by a resident of one state for an injury in another is reported where the recipient lives. States with no income tax, including Texas, Florida, Tennessee and Washington, tax nothing.

Interest on judgments is governed by state law, which sets the rate and the date from which it runs, prejudgment interest from the injury or the filing in some states and post-judgment interest from the verdict everywhere; the interest is taxable regardless of the state. Punitive damages availability and caps are state law; their taxability is federal. Wrongful death damages are excluded as damages for physical injury in most cases, with the state's characterization of the damages affecting the analysis.

Workers' compensation benefits are excluded from income under a separate federal provision. Disability insurance benefits may be taxable depending on who paid the premiums. PIP and medical payments benefits paid by an auto insurer are reimbursements of medical expenses and are not income, subject to the prior-deduction rule.

For an excluded settlement, the attorney's contingency fee has no tax consequence: the whole amount is excluded, and the fee is simply a cost paid from excluded money. For a settlement with a taxable component, punitive damages or interest, the treatment of the fee attributable to that component is a problem under current federal law: the full taxable amount is income to the recipient, and the fee paid to the attorney is generally not deductible by an individual, so tax is owed on money the recipient never received.

This result, which Congress addressed for certain employment and civil rights claims but not for personal injury claims generally, makes the allocation between compensatory and punitive damages in a settlement agreement consequential, and it is a reason parties sometimes resolve a case with a punitive exposure on a compensatory basis. A tax professional and the attorney address it before the agreement is signed.

Medicare, Medicaid and health insurer liens, and the attorney's fee, reduce what the recipient nets but do not change the taxability of the gross; an excluded settlement remains excluded whatever is paid from it.

A car accident settlement for a physical injury is generally not taxed, with punitive damages, interest, non-physical emotional distress and previously deducted medical expenses as the exceptions, and the settlement agreement's allocation and the records of the injury are what support the exclusion. The questions to answer before signing are whether any taxable component exists, how the agreement allocates the amount, and whether a prior deduction was taken. This is general information and not tax advice; a tax professional reviews any significant settlement, and most personal injury attorneys coordinate with one.

Ask Legal Matters is a free claim-review request service, not a law firm, and does not provide tax advice. Requests may be shared with independent attorneys and legal services partners who handle inquiries in your state, and an attorney must evaluate the facts before anyone can say what the claim is worth. If you have an injury claim and questions about how a settlement would be treated, you can request a free claim review.

• Car Accident Claims in the United States: The Complete Guide
• Workplace Injury Claims: Workers' Compensation and Third-Party Lawsuits
• Wrongful Death Claims: Who Can File, Deadlines and Damages
• Accident in a Borrowed Car: Whose Insurance Pays
• Accident on Icy Roads or in Bad Weather: Who Is at Fault
• Airbag Did Not Deploy in a Crash: Can You Sue, and Whom?
• Amputation Injury Claim: Prosthetics and Lifetime Costs
• At Fault in a Car Accident? Comparative Negligence Explained
• What Is the Average Car Accident Settlement? What Sets the Value

Need local rules? Choose your state from the injury law guides hub or read the statute of limitations by state.