We are often asked by our clients if the proceeds or damages from a personal injury case settlement are taxable. The general answer is that personal injury settlement proceeds are not taxable on their receipt by the taxpayer/client. There are some important exceptions.
It is fair to say that a general settlement (where the proceeds are not specifically categorized) is not taxed on the settlement proceeds. In other words, if a client receives a settlement of $50,000 there is no tax on receiving the $50,000 of personal injury proceeds. Of course, once the personal injury settlement money is placed in a bank and interest is earned on the money, the interest is taxable just like any other account.
There has been a new decision out of the District of Columbia federal circuit court of appeals which ruled that emotional distress damages and damages to give compensation for damage to professional reputation are also not taxable damages under the Internal Revenue Code. In a case called Murphy v. IRS., decided August 22, 2006, by the United States Court of Appeals, the court ruled as follows:
It is clear from the record that the damages were awarded to make the plaintiff emotionally and reputationally whole and not to compensate her for lost wages or taxable earnings of any kind…. Every indication is that damages received solely in compensation for a personal injury are not income within the meaning of the Sixteenth Amendment.
Supposedly, the IRS is planning to appeal this federal decision to the U.S. Supreme Court.