Damages for Physical Injury or Illness

The general question is, "if I get compensation for damages someone else has done to me, is the money taxable?"
As with any tax question the answer is, it depends.  That money is usually taxable, however.

A more specific question is, "if I get compensation for physical injury or illness that someone else has inflicted upon me, is the money taxable."
The answer is still, it depends, but settlements like these are usually not taxable.

Here is the general rule.

1. The settlement has to be for a tort or tort-like action. "Tort" is one of those legal-babble terms that means you got damaged by someone else. You don't have to go to court for this requirement to be met.
2. The settlement has to be because of a physical injury or illness. Making you bleed is what we call a "good fact." Internal bleeding counts. So do bruises.

Next, the exceptions: If the payment, or part of it, is for medical bills that have already been deducted on a tax return, that part is taxable income. Also, if the payment, or part of it, is labeled "punitive damages," that part is taxable. That's it. Those are the exceptions. Everything else is excluded from taxable income.

"So what's the big deal," you might ask. "It doesn't seem like rocket science."

You would think. However, there are a lot of people running around out there who believe there are other exceptions. Here are some myths in descending order of pervasiveness.

• Myth #1: If you get physically injured by someone else and they compensate you for lost income, that part is taxable. Not so! It makes no difference how the dollar value of the physical injury is computed, the payment is still tax free.
• Myth #2: If the compensation includes an amount for emotional distress or something similar, that part is taxable. This one is trickier because another part of the tax code says compensation for emotional distress is taxable. However, that other part refers to emotional distress when that's the only damage done to the person. If the emotional distress (including pain and suffering) is a result of the physical injury, the payment is still tax free.
• Myth #3: Payments to anyone besides the injured party are taxable. Wrong again. If a person is banged up in an automobile accident and the spouse gets a payment for his/her suffering as a result of that accident, those payments are tax free. If a spouse is killed by someone else in an accident and the settlement results in the estate getting money, the estate does not have taxable income. If that settlement goes to the surviving spouse or other family member, the payment is still tax free.

If you meet the criteria under "general rule" and you're told by your tax return preparer that the lost wages part of your settlement is taxable, tell them to read IRC Section 104, Reg Section 1.104-1, and most importantly, Revenue Ruling 87-95. If they still don't understand, drop me a line. Our rates, in my opinion, are reasonable. (I have to say it's just my own opinion that our rates are reasonable because the AICPA has said that a general claim of charging "reasonable" rates is unethical.)

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