Proceeds from a wrongful death settlement are designed to compensate heirs and loved ones when someone dies as the result of another’s negligence or neglect. In many cases, such settlements don’t require the recipients of the funds to pay the Internal Revenue Service a portion of the proceeds. That’s not always the case, however, and your tax obligation often depends on where you live.
Wrongful Death Basics
As the IRS notes, wrongful death lawsuits usually encompass claims for physical and mental injury, as well as punitive damages for the conduct that led to the death. Claims related to physical injury are excluded from gross income for tax purposes. For example, any portion of the settlement related to medical costs associated with the deceased’s treatment would not be taxable. Claims for emotional distress aren't taxable if they can be tied to a physical injury or if the claim is for a specific course of treatment. If not, however, settlement money explicitly designated for emotional distress may be taxable.
In general, punitive damages have to be counted in figuring out gross income. In absence of state law that contradicts this, the punitive damages portion of the settlement must be declared to the IRS, and taxes may need to be paid on the proceeds. The same is true of any portion of the settlement designed to replace lost wages, because that replaces earnings that would normally be subject to taxes.
Some states, such as Alabama, explicitly exclude wrongful death settlements from taxation. Others mandate that wrongful death settlements can only bring punitive damages, not compensatory ones. If that's the state law, the settlement may not be taxable. But that exception on the taxation of punitive damages only holds if it's true for every wrongful death case in the state. If only some cases are limited in this way, such as a state with a workers’ compensation act that restricts only some wrongful death settlements to punitive damages, the IRS would consider the settlement funds taxable.
Medical Expenses Noted
Wrongful death settlement proceeds set aside for medical benefits may draw the interest of taxing authorities. If the deceased received Medicare-subsidized health care that related to the cause of death, the Secretary of the Department of Health and Human Services may seek reimbursement of medical expenses from the estate. In addition, if the deceased or someone who could claim him as a dependent deducted medical expenses related to his care in previous tax years, settlement funds that reimbursed those specific medical costs would be taxable.
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