If you're involved in a serious automobile mishap, potential tax implications are probably your last concern. In most cases, there are none – that's the good news. Unfortunately, if your lawsuit recovery does turn out to be taxable, the Internal Revenue Service might end up taking a hefty portion of your settlement.
Regulation 1.104-1(c) of the Internal Revenue Code states unequivocally that the portion of your lawsuit proceeds attributable to personal injuries is not taxable. The rule applies whether a judge or jury orders the damages, or if you reach a settlement with the other driver's insurance company. You don't have to include this money as income on your tax return.
If you recover money for damages to your automobile, this isn't taxable either. As far as the IRS is concerned, the purpose of this money is to put your property back in the condition it was in before the other driver hit you. It doesn't matter if you don't actually use the money to repair your vehicle. You won't be taxed on it unless the insurance company awards you more than the repairs should reasonably cost, but this rarely happens. For example, if you're paid $6,000 but the estimate for repairs was only $3,000, you'd have to include the extra $3,000 as income on your tax return.
Lawsuit awards for emotional distress fall into a bit of a gray area. If you're distressed over your injuries, settlement money allocated to pain and suffering is not taxable. If your distress is unrelated to injuries, however, you must claim the money on your tax return. For example, if you suffer no personal injury but your beloved dog is killed in the crash, you'd have a claim for distress. Because you weren't hurt, it's taxable. If you suffer injuries severe enough that you're unable to perform the basic tasks of caring for yourself, and if this causes you such angst that your settlement includes compensation for it, it's not taxable.
Punitive damages generally aren’t included in accident settlements – they're meant as punishment for the other driver because he did something so egregiously negligent, the court or a jury wants to deter him – or others – from doing the same thing again. If they are included, this portion of your settlement is taxable. Exceptions exist in wrongful death suits, however, if the accident actually resulted in the death of a passenger and your state's laws allow only for this type of damages in accident suits.
Personal injury attorneys usually charge clients on a contingency basis. When they recover a settlement, they deduct a percentage of the money as compensation and turn the balance over to the client. If your lawsuit money is taxable, the portion you pay your attorney counts as income to you, even though you don't actually receive it. You can claim a corresponding deduction for your attorney's fees if you itemize on your taxes, but this typically doesn't help much – the Internal Revenue Service imposes limitations so the deduction doesn't match your attorney fees dollar for dollar. If your settlement includes both taxable and non-taxable components, you can only take a deduction for the percentage attributable to the taxable part of your award.
If you're self-employed and you've claimed depreciation for the business use of your automobile, speak with an attorney before you do your taxes. This can affect the general rule that compensation for damage to your vehicle is not taxable. If you took any medical expense deductions for treatment you paid for when you were injured, and if your settlement eventually reimburses you for these costs, you'll probably need the help of an attorney or an accountant in this case as well. You'll have to recapture these deductions. Finally, any portion of your settlement representing interest is taxable.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.