Uncle Sam wants you to declare every single penny of taxable income. Failure to do so may result in an audit (which makes root canal without anesthesiology seem like a picnic) and hefty fines. But what exactly is taxable income? The courts have defined it as “all accession to wealth, clearly realized, over which you have dominion.” Clear as mud, huh? Does that count wealth you acquired as the result of being injured in a car accident? In an effort to shed a little clarity on the subject, here are some general rules of thumb regarding taxable income and insurance settlements. Situations differ, and you are cautioned to consult the IRS or your professional tax preparer about your specific tax liabilities.
Are Personal Injury Damages Settlements Taxable?
No. Generally speaking, any cash you receive to restore you to your former state doesn’t count as taxable income. So if you suffered a bodily injury in an accident that was caused by someone else, any cash you receive as a result of settlement in or out of court with that person’s insurance company are not taxable income. However, if your settlement includes compensating you for wage you lost while unable to work as a result of the accident this is considered a personal income settlement and is taxable. As a rule, settlements for emotional distress are taxable, except perhaps for any portion you use to pay for medical care required to treat your emotional distress.
Are Property Damages Settlements Taxable?
No. Here again, any cash settlement you receive from an insurance company to restore your property to its original state does not count as taxable income. Note that if you negotiate settlement for repairs that are not required, the additional money may be taxable. An example might be negotiating with the insurance company to pay to paint your entire car, when only a fender was repaired.
Are Punitive Damages Settlements Taxable?
Probably. The purpose of punitive damages, which are awarded by a jury or court, is to punish the defendant for outrageous misconduct, as well as to discourage that behavior in the future. Behavior meriting the awarding of punitive damages is usually characterized as malicious, oppressive, violent, reckless, fraudulent, or otherwise acting with utter disregard for your (the plaintiff’s) rights and interests. An example might be if, after running into you while you’re pulling your car out of a parking spot, the driver backs up and runs into you again. In addition to any property and personal injury damages you would be entitled to from the driver’s insurance company, you might also sue for punitive damages. Because this type of damage doesn’t fit any category normally covered by an insurance company, your settlement may be considered taxable income.
For more information about taxable income on insurance benefits, please see Are Insurance Benefits Taxable?
For information about insurance premium tax deductions, please see, How to Maximize Your insurance Tax Deduction for 2010, Key Man Life Insurance and Tax Deductions, and Small Business Insurance Tax Deductions for 2010.