What is an Auto Accident Settlement?
An auto accident settlement is a legal agreement reached between parties involved in a car accident that resolves disputes without a trial. In most cases, auto accident settlements result in the at-fault driver’s insurance company compensating the injured party for medical bills, pain and suffering, and emotional distress.
Whether there is a tax on auto accident settlement awards largely depends on the IRS’ definition of taxable income. According to 26 USC § 61(a) of the U.S. tax code, “gross income includes all income from whatever source derived”. In other words, money obtained by a settlement is mostly taxable–except money awarded from physical and personal injury settlements for medical expenses and mental anguish.
Nontaxable Elements of Auto Accident Settlements
Plaintiffs awarded the following compensatory damages do not have to pay taxes on the compensation, regardless of the amount:
- Physical injuries (medical expenses, pain and suffering, future medical bills, rehabilitation)
- Emotional distress (psychological trauma caused by injuries is generally nontaxable)
- Vehicle damage (repair or replacement costs, reimbursement for using a rental car)
Taxable Elements of Auto Accident Settlements
- Lost wages (compensation for income lost due to being injured in an auto accident is subject to federal and state income tax)
- Punitive damages (when at-fault drivers commit egregious acts with their vehicles, a judge may award punitive damages to punish the driver by deterring such future behavior. Punitive damages are considered earned income by the IRS and are taxable)
- Pre-judgment/post-judgment interest (settlements may accrue interest that affects tax reporting instructions)
What is a Structured Auto Accident Settlement?
When the injured party agrees to receive settlement funds in a series of periodic payments over time instead of a one-time lump sum, that is called a structured settlement. This type of settlement is typically the outcome of negotiations between the parties involved in an auto accident, their personal injury attorneys, and the litigants’ insurance companies.
Payments received over time from a structured settlement are nontaxable. For example, John received a $200,000 auto accident settlement that he chose to put into a structured settlement. John had $5,000 deposited into his bank account every month for a little over three years. He did not have to report the monthly payments to the IRS as income.
However, if John had elected to receive a lump-sum settlement of $200,000, and invested the entire amount in the stock market (or other investment opportunity), his future investment earnings would be considered income and taxable by the IRS.
Tax on Auto Accident Settlement: Reporting and Filing Requirements
The IRS provides Publication 4345 to help taxpayers determine what types of settlement damages are taxable and which are not. Maintaining documentation of the settlement agreement, including details about the breakdown of damages awarded, is necessary to ensure you do not trigger an IRS audit after filing tax returns.
When it’s time to file your taxes, consider consulting with a tax professional or an attorney who specializes in auto accident settlement taxation. Also, be aware that state tax laws regarding the taxation of settlements may vary and diverge from IRS guidelines.
Before Accepting an Auto Accident Settlement, Seek Professional Advice from a Personal Injury Attorney
Resolving your auto accident settlement may be one of the most important decisions you ever make. Take steps to prioritize your financial well-being and protect your legal rights by contacting the personal injury attorneys at The Ledger Law Firm.
We have the experience and expertise to accurately assess the full extent of your damages, negotiate on your behalf, and ensure that you receive the fair compensation you deserve. Secure the best possible outcome for your auto accident settlement case without paying more in taxes than necessary by calling The Ledger Law Firm today at (800) 300-0001.