Those in a personal injury action often realize they had not considered the tax obligations they may have when awarded a verdict or settlement. The good news is that in general, the proceeds received in a personal injury case are not taxable. This applies when the compensation is for claims of bodily injury and will include damages for pain and suffering as long as they resulted from the injury incurred. Medical expenses are one variable needing consideration for tax purposes, particularly in claims taking multiple years to be resolved.
If you took itemized deductions specifically for medical costs relating to the injury in prior years, the benefit amount is taxable and is to be reported on Form 1040 on line 21 as “other income”. If you deducted medical expenses associated with the injury over more than a single tax year, the taxes are then allocated on a “pro-rated” (proportional) basis. In Publication 4345, the IRS does consider proceeds allocated for interest, punitive damages, emotional anguish & distress, employer discrimination, or injuries to reputation as taxable. In these circumstances, you may want to reference “recoveries” in IRS Publication 525 and consult an attorney or tax professional.
Medical Expense Deductions & Emotional Distress/Anguish
The proceeds for allocations using terms such as mental distress or emotional anguish that are directly the result of the physical harm, injury or illness, are not considered taxable. It is critical to differentiate these damages from those that will be taxable since they did not originate based on the physical injury involved in the claim. The amount that is taxable may be reduced by medical costs for mental distress or emotional anguish that were not deducted in prior tax years or those that resulted in no tax benefits. It is generally recommended that an award recipient generate a basic written statement including the total amount and lists medical costs deducted previously and not deducted.
Awards including financial compensation imposed because the at-fault party acted with malice, such as an intentional action to injury or harm, are considered punitive damages. These damages serve to punish a defendant and as a deterrent to others. Damages deemed punitive are taxed and reported on Form 1040 line 21 for “other income”. Those receiving awards likely to have a large taxable amount may consider consulting an attorney or tax professional regarding estimated tax payments, described in IRS Publication 505.
Maryland State Taxes & Interest Considerations
In Maryland's state and local tax forms and instructions, the lone provision referring to civil awards for damages concerns those deemed as noneconomic damages resulting from claims involving discrimination under IRS Code Section 62. Two variations of interest also may be considered. Pre-judgment interest is generally not eligible for recovery unless specified in an agreement. One exception is when the court determines a defendant delayed the action unnecessarily for some period of time. Post-judgment interest added to an award is typically recoverable at a 10% rate per year.