Personal Injury Settlements Generally Not Taxable

I have heard it been said that next to being shot at and missed, nothing is really quite as satisfying as an income tax refund. While almost all can appreciate that sentiment, I would take it one step further and add that nothing is quite as satisfying as not having to pay taxes in the first place.

It’s hard enough being injured, and then having to bring a lawsuit to obtain proper compensation and payments for your injuries. Can you imagine the impact it would have if you then had to pay income taxes on those monies? Thankfully, the government realized that injury settlements are not earned income. Rather, they compensate the injured victim for the pain, suffering, and disabilities they suffered at the hands of another’s carelessness. Accordingly, they generally, and rightfully, are not taxable.

Section 104(a)(2) of the Internal Revenue Code excludes from gross income amounts received from personal injury awards. It provides that gross income does not include any damages received, whether by suit or agreement and whether as lump sums or as periodic payments, on account of personal injury or sickness.

While this tax exclusion is about as old as the federal income tax system, it has caused much controversy in the courts and some clear exceptions have emerged since this provision was enacted back in 1918.

For instance, money paid for punitive damages is taxable. The legal rationale for this exception is that punitive damages are primarily intended to punish and discourage the behavior of the defendant, not to compensate the plaintiff. Lost earnings are also taxable if a portion of the settlement is specifically designated as compensation for lost income. Finally, money paid for psychological injuries may be taxed.

However, it is important to understand that once settlement proceeds have been received, the taxability of that money is just like any other money you invest or put in a savings account. When you invest those monies into taxable investments, then any profit or gain you achieve is then taxable.

Our clients at Mainor Eglet Cottle are both relieved and even a little surprised when we inform them that generally, their personal injury verdict or settlement will not be taxed by the IRS.

Dennis Rodman’s Contribution To Personal Injury Tax Law

As mentioned above, the tax exclusion for a personal injury settlement has caused much controversy in the courts. It is fitting, then, that an act from an individual as unique and controversial as Dennis Rodman led to a unique landmark tax law case, Amos v. Commissioner, 2003 Tax Ct. Memo LEXIS 330 (2003), which created law allowing the IRS to tax Personal Injury settlements which include Confidentiality Provisions.

Outside the legal community, Dennis Rodman is well known for his ferocious defense and rebounding skill during his long career in the NBA, as well as his tattoos, piercings and wild off-the-court partying lifestyle. In the legal community, his name has become the short hand reference for income tax concerns for the unwary personal injury plaintiff.

On January 15, 1997, Dennis Rodman was still in his heyday as a defensive specialist with the World Champion Chicago Bulls, and the Bulls were playing the Minnesota Timberwolves. After scrambling for a loose ball, Rodman fell into a group of photographers on the sidelines. While getting up, Rodman kicked a cameraman, Eugene Amos, in the groin.

Amos later sought treatment for groin and back injuries, filed a police report, and retained a lawyer to pursue personal injury claims against Rodman. Before a formal lawsuit was filed, the attorneys for Amos and Rodman negotiated a $200,000 settlement agreement, which included a Confidentiality Provision stating that Amos had to keep the nature and amount of the settlement secret.

Relying on well-settled law that personal injury settlements were not taxable, Amos did not claim the $200,000 as part of his gross income on his 1997 tax return. To his surprise, the IRS maintained that he should have claimed the money as income because his injuries were minimal and the monies were really paid for the confidentiality provision.

At the end of the case, the court determined that the $200,000 settlement had to be allocated between the amount paid for the personal injuries, which was exempt from taxation, and the amount paid for the Confidentiality Provision, which was taxable. Ultimately, the court arbitrarily allocated $120,000 to the personal injuries and $80,000 to the Confidentiality Provision.

Because confidentiality provisions can lead to tax consequences in personal injury cases, you need to be aware and seek out competent counsel to help prevent the government from getting money that should be in your bank account.

Each situation is unique and this article is not intended to constitute tax advice for any person’s individual situation. The information contained in this article is provided for informational purposes only. You should consult a tax attorney or an accountant if you need help with your taxes or for questions about taxable income.