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When Is Personal Injury Compensation Tax-Free?

Remember Dr. David Dao, the man who was dragged off a United Airlines plane even though he had paid for his seat? His attorney negotiated a settlement with the carrier, and though its terms were confidential, most observers assume that the settlement was substantial.

It turns out that in all likelihood, Dr. Dao will not have to pay income taxes on the amount of the settlement. That's because in most cases, personal injury compensation is exempt from federal income taxes as well as state taxes. In this blog post, we will discuss the tax treatment of personal injury compensation, when such compensation is exempt from taxation, and when it may be taxable.

Will You Have To Pay Taxes on Your Personal Injury Compensation?

Generally speaking, personal injury settlements and jury awards that compensate for medical costs are exempt from federal and Illinois income taxes. Noneconomic compensation for physical pain and emotional suffering can also be exempt, but with one proviso: the pain and suffering must be directly related to the physical injury. Attorney fees that a plaintiff receives as part of a settlement are also tax-exempt. Plaintiffs may not even have to report the proceeds of a settlement or jury award on their tax returns.

However, some categories of personal injury compensation can be subject to taxation:

Lost wages or income - The IRS considers this as taxable income, and it must be reported on the recipient's tax return.

Interest - If the settlement or award includes interest, this will have to be included on the tax return and it will be subject to taxation.

Punitive damages - These are designed to make an example of the defendant in the eyes of the public and to serve as a warning to other parties who behave in a similar manner. Because punitive damages are not designed to compensate for the specific losses of the plaintiff, they are subject to taxation.

Emotional suffering and anguish not related to a physical injury - Compensation for non-physical injuries such as loss of reputation, harassment, or invasion of privacy are taxable.

When a settlement or jury award contains compensation for a taxable item, that portion of the amount must be listed on the recipient's tax return for the year he or she receives the money. However, some personal injury cases are resolved through structured settlements. In a structured, the defendant spreads out payment of compensation over several years. When a structured settlement contains taxable items, those taxable items must be included on the recipient's tax returns each year.

An experienced attorney can answer your questions about personal injury compensation, and if necessary, advise you of your legal options.

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