We have been diving into the world of taxation of personal injury settlements. In previous articles, we have discussed the basic information about what is taxable and what is not in your personal injury settlement.
In this article, let us talk about this IRS document that talks about settlements and taxability. Let us begin our dive by looking at when specific parts of your settlement are included in gross income and when it is not included.
Personal physical injuries or physical sickness
For personal physical injuries or physical sickness, the IRS shared the following information:
When not included:
If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income.
If you receive a settlement for personal physical injuries or physical sickness, you must include in income that portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit. If part of the proceeds is for medical expenses you paid in more than one year, you must allocate on a pro-rata basis the part of the proceeds for medical expenses to each of the years you paid medical expenses.
This seems quite complicated especially when you are doing it alone. Here at Haque Legal, we can help ensure that you pay the right taxes for your settlement when we make an accounting of what you have received for your personal physical injuries or physical sickness.
Emotional distress or mental anguish
Emotional distress or mental anguish is another concern that clients have. Let us differentiate when it is included and when it is not included according to the IRS:
When not included:
The proceeds you receive for emotional distress or mental anguish attributable to a personal physical injury or physical sickness are treated the same as proceeds received for Personal physical injuries or physical sickness above.
If the proceeds you receive for emotional distress or mental anguish do not originate from a personal physical injury or physical sickness, you must include them in your income. However, the amount you must include is reduced by: (1) amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted and (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit. Attach to your return a statement showing the entire settlement amount less related medical costs not previously deducted and medical costs deducted for which there was no tax benefit.
When it is included you should report it as “Other Income” on line 8z of Form 1040, Schedule 1.
Lost wages or lost profits
On the other hand, lost wages are always considered to be taxable. The only concern that most individuals would have is whether the lost wages are part of taxable income or employment tax.
According to the same IRS document, the following answers the question:
- If you receive a settlement in an employment-related lawsuit; for example, for unlawful discrimination or involuntary termination, the portion of the proceeds that is for lost wages (i.e., severance pay, back pay, front pay) is taxable wages and subject to the social security wage base and social security and Medicare tax rates in effect in the year paid. These proceeds are subject to employment tax withholding by the payor and should be reported by you as ‘Wages, salaries, tips, etc.” on line 1 of Form 1040.
- If you receive a settlement for lost profits from your trade or business, the portion of the proceeds attributable to the carrying on of your trade or business is net earnings subject to self-employment tax. These proceeds are taxable and should be included in your “Business income” reported on line 3 of Form 1040, Schedule 1. These proceeds are also included on line 2 of Schedule SE (Form 1040) when figuring self-employment tax. For more information about reporting self-employment income and paying self-employment tax, see Publication 334, Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ).
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The article that you have read is based on general applications of the law. It is not legal advice and it is not to be construed as any legal consultation with the firm. No client-attorney relationship is created when you read the articles we have provided.
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