Is Lawsuit Settlement Money Taxable in New York? [Personal Injury & Medical Malpractice]

If a personal injury case brought in New York State is successful, the injured person (and also members of their family, under certain circumstances) will receive financial compensation for their injuries, which can sometimes be a substantial amount of money. After all, under our system of civil laws that apply to such cases, financial compensation is essentially the only remedy available for injured people if they suffer physical harm due to the negligence of another. For many seriously injured people, the amount of money awarded is far more money than they have ever had at any one time in their entire life. However, it’s important to understand the tax obligations of such personal injury settlements. Generally, compensatory damages received for physical injuries or physical sickness are not taxable, as per federal tax laws and tax implications. This includes compensation for medical expenses, lost wages, and pain and suffering. Nevertheless, there are exceptions, particularly concerning punitive damages or interest accrued on the lawsuit settlements, which may be subject to taxation. Therefore, recipients should consult with a professional tax preparer to ensure they understand their current situation and comply with all relevant tax obligations.

Is Settlement Money Taxable? An Overview

Settlement money is usually not taxable for residents of New York State. As a general rule, proceeds of cases in which you are compensated for the consequences of physical injuries are not taxed. This is because, as a general matter (and in very simplistic terms), only “profits” are considered income that can be taxed, and any recovery had in a personal injury lawsuit is not considered to be profit but is simply a repayment of money that was taken away from the injured person due to the negligent conduct of another person.

Tax Treatment of Personal Injury Settlements

This article will explain the basics, and a selection of specific rules and circumstances, of how recoveries in injury cases are treated under the New York State and Federal tax systems, and will hopefully provide a clearer understanding of how recoveries in personal injury and medical malpractice cases in New York are taxed. Please be aware that all cases are different, and you must be sure to consult your attorney to make sure that you are properly advised of the tax consequences applicable to your particular case before making any financial decisions regarding any money you may receive in a settlement or judgment.

Personal Injury Settlements Are Not Income And Thus Are Not Taxable

When a person suffers a serious injury, they experience a loss that is referred to as “damages” under the personal injury laws. This loss, in a personal injury lawsuit, is categorized into different elements, which can include:

• pain and suffering
• lost wages (both past and future)
• medical bills (both past and future)
• other categories of damages that may arise depending upon the circumstances of the particular case

When a jury awards damages to an injured plaintiff in a personal injury lawsuit, the jury is, essentially, giving the plaintiff money to compensate them for what they have lost due to having been injured. This concept is the same when a personal injury plaintiff receives a settlement for the damages they have incurred.

Tax Implications of Personal Injury Awards

As almost every income taxpayer knows, the only amounts of money that are taxable under both State and Federal tax laws are those that are considered “income”. Generally, in very simple terms, income means “profit” (revenue minus expenses), and only profits are taxable.

Compensation is Not Considered Taxable Income

Because a personal injury award is only compensation for something that the injured person has lost, it is not considered “income”. The whole idea of a personal injury lawsuit is to seek compensation for what an injured person has lost (to make them whole after an injury), and so whatever money is awarded or received in an accident lawsuit is not considered income because none of it is profit. It is simply the repayment of money that a negligent defendant took away from the plaintiff when they caused the plaintiff’s injuries. This distinction is crucial in understanding the tax treatment of personal injury settlements.

Importance of Professional Advice

The recipients of personal injury settlements must understand the nuances of tax law as it applies to their compensation. Consulting a knowledgeable tax attorney about lost wages, physical injury, and emotional distress after a personal injury settlement can provide tailored advice and ensure compliance with all applicable tax benefit regulations. Each case is unique, and professional guidance can help individuals make informed financial decisions regarding their legal settlements.

How Does the Federal Tax Code Treat Recoveries?

Under Section 104(a)(2) of the United States Tax Code, any money received as compensation in a personal injury or medical malpractice lawsuit (whether by a jury verdict or settlement) is taxable income under the income tax laws. This very important law specifically addresses both verdicts and settlements and states that, unless punitive damages are awarded, you do not have to declare any money that you receive in a personal injury or medical malpractice lawsuit as income on your federal tax returns.

Exclusions and Exceptions

However, because there are certain exclusions to this exemption, you should always consult with your lawyers, as well as an accountant, before making a final determination regarding whether or not and how, in your particular case, this important rule applies. Usually, in personal injury and medical malpractice lawsuits, dealing with lost wages, personal physical injuries, and emotional distress, punitive damages are not awarded, but only “compensatory” damages, which are specifically excluded from taxability under this rule.

Compensatory vs. Punitive Damages

One common misconception about lawsuit settlements is that all settlement money is subject to taxation. This belief often stems from a general misunderstanding of how the Internal Revenue Service (IRS) treats different types of damages awarded in personal injury cases. Many people incorrectly assume that any money received, regardless of its purpose, must be reported as taxable income. However, this is not entirely accurate. The IRS distinguishes between compensatory damages, which are meant to reimburse the plaintiff for actual losses suffered, and punitive damages, which are intended to punish the defendant and deter future misconduct. Thus, in the vast majority of personal injury and medical malpractice cases, no tax will be owed. It is crucial to differentiate between compensatory and punitive damages, as the latter are not exempt from taxation and could significantly affect the tax obligations associated with a settlement payment or verdict. Another prevalent misconception is that compensatory damages, which cover pain and suffering, medical expenses, and lost wages, are always taxable. In reality, under Section 104(a)(2) of the United States Tax Code, compensatory damages for physical injuries or sickness are generally exempt from federal income tax. This means that the money received to cover medical bills or to compensate for pain and suffering is not considered taxable income. However, it’s important to note that any interest accrued on the settlement amount and punitive damages awarded are indeed taxable and must be reported.

Importance of Financial Planning

We advise, however, that you not spend too much of any money that you are awarded in a settlement or verdict before speaking to a tax professional and receiving a final and definitive answer on this particular issue. Proper guidance can prevent unexpected tax liabilities and ensure that you are fully aware of your financial situation following a legal recovery.

How Does the New York State Tax Code Treat Recoveries?

Thankfully, the New York State rule is essentially identical to the Federal rule regarding the taxability of any money received in a settlement or verdict in a personal injury or medical malpractice case. Of course, you should always consult with your lawyer and a tax professional before spending any of the money that you may receive in such a case to ensure that the particulars of your case do not raise any tax liabilities (no two cases are identical, so you should always consult with a tax professional to be safe).

Potential Tax Deductions and Exemptions

While compensatory damages for physical injuries are generally exempt from taxation, there are potential tax deductions and exemptions that individuals should be aware of when handling their personal injury settlements. For instance, if a portion of the settlement is allocated to cover medical expenses that were previously deducted on a tax return, that amount must be reported as income in the year it is received. This is to prevent a double benefit—deducting the expense in one year and excluding the reimbursement in another. Furthermore, plaintiffs may also be eligible for deductions related to legal fees incurred during the lawsuit. Legal expenses that are directly related to obtaining taxable damages may be deductible. However, the tax treatment of legal fees can be complex and varies depending on the nature of the settlement. Plaintiffs should work closely with a tax professional to identify all potential deductions and to ensure compliance with IRS regulations. This proactive approach can help maximize the financial benefit of the settlement and minimize any unexpected tax burdens.

What if I Want to Purchase an Annuity to Receive Future Periodic Payments?

In personal injury and medical malpractice cases involving extremely substantial amounts of money, or where the plaintiff is a child or a person with mental disabilities, purchasing an annuity contract with the settlement proceeds is often advisable. An “annuity” contract refers to an arrangement whereby a plaintiff makes a deal with an insurance company whereby the plaintiff pays over the lump sum of his or her settlement or verdict award to the insurance company in exchange for a stream of future periodic payments, the total of which amount to far more than the original lump sum awarded in the plaintiff’s personal injury or medical malpractice case. Related Article: Interest on Recoveries in Personal Injury and Medical Malpractice Cases After all, when an award is in the multiple millions of dollars, usually a plaintiff does not need all of the money in a lump sum and is best served by setting up a stream of income that will last their entire lifetime.

Are Annuity Payments Taxable Income?

Under the Federal and New York State tax laws, even though these annuity payments ultimately result in more money being given to the plaintiff than the value of their settlement or verdict, if the annuity is handled correctly, the plaintiff will not have to pay income tax on the annuity payments – even though they are receiving a “profit” above and beyond what they would have received from the settlement or verdict alone. It is important to know that, if a plaintiff receives settlement or verdict funds in a lump sum, and then, after taking possession of those funds, goes out and invests those funds, any profits made will be taxable. However, if the plaintiff does not take possession of the funds, but arranges to have the settlement or verdict funds deposited directly into an annuity as part of the settlement, or by court order (as in the case of a verdict), the payout from the annuity is not taxable.

Call Us Today for a Free Consultation Regarding the Taxability of Your Settlement or Verdict 

Our Bronx personal injury and medical malpractice lawyers deal with these issues every day and offer free consultations on these and any other issues related to personal injury and medical malpractice lawsuits when you call us today at (718) 865-3770. We understand the complexities of tax law pertaining to settlements and verdicts. Whether you’ve recently received a settlement or are in the midst of negotiations, our experienced attorneys can provide personalized guidance to ensure you understand the tax implications and can make informed decisions regarding your financial situation.