Understanding Tax Implications of Car Accident Settlements

Good tax news for car accident victims! Many aspects of your settlement are not taxable. That means, the oftentimes large lump sum settlements and judgments paid to injured car accident victims are tax free.

Find he general rule regarding taxability of amounts received from settlement of lawsuits and other legal remedies in Internal Revenue Code (IRC) Section 61. Section 61 provides that all income is taxable whatever the source. Other sections of the Code reflect exceptions to the general rule. Discrimination claims and amounts paid to resolve physical injury are the most common exceptions . But, as shown below, some aspects of amounts paid in injury and discrimination cases are taxable.

Categorizing settlement payments is critical to understanding what aspects are taxable.

Categorization is the key to determining whether the settlement payment is taxable or non-taxable.

In the first group are physical injury related claims. In the second group are claims non-physical injury related claims. Within the groups, the claims typically fall into three categories:

• actual damages resulting from physical or non-physical injury
• emotional distress damages arising from the actual physical or non-physical injury;
• and punitive damages

Amounts in a settlement not subject to tax

IRC Section 104 sets forth an exclusion from taxable income with respect to lawsuits, settlements and awards. Considering the the facts and circumstances surrounding each settlement payment is critical to determine the exemption status.

“The key question to ask is: What was the settlement (and its corresponding payments) intended to replace?”

Grouping settlement payments to determine taxability

To determine whether a settlement payment is taxable or non-taxable, dividing the award or settlement into two distinct groups is the key. The first group includes claims relating to physical injuries, and the second group is for claims relating to non-physical injuries. Within these two groups, the claims usually fall into three categories:

Actual damages resulting from physical or non-physical injury

Money to pay medical bills including for rehabilitation and compensation for physical pain is not taxable

emotional distress damages arising from the actual physical or non-physical injury

Payments for emotional distress stemming from an injury is not taxable

property damage

Money for the replacement or repair of your damaged vehicle or other property are not taxable.