Most forms of compensation in California car accident insurance settlements are not taxable. However, certain kinds of compensation are.
26 U.S. Code § 104 excludes compensation for physical injuries from gross income. California typically follows federal tax rules for car accident settlements. The state does not impose separate state taxes on non-taxable compensation in personal injury settlements.
This article covers what types of compensation in California car accident cases are and are not taxable so those who have been injured in car accidents can have an idea of what parts of their potential settlement may or may not be taxed.
Call our experienced car accident lawyers today for a FREE consultation at (800) 718-4658 or contact us if you or a loved one has been injured or killed in a car accident. We can help you recover financial compensation for medical bills, lost wages, loss of earning capacity, pain, suffering, wrongful death and more, and we will charge you no legal fee until we win your case.
Key Takeaways
- Compensation for physical injuries, medical bills, pain and suffering related to a physical injury, and property damage is generally not taxable.
- Punitive damages, interest on awards, and compensation for lost income and emotional distress not related to a physical injury are taxable as ordinary income.
- Tax exposure is directly affected by how a settlement is allocated and structured.
- You can potentially minimize avoidable tax liability by working with an attorney and a CPA before signing settlement documents.
Table of Contents
- Which Parts of a Car Accident Settlement Are Taxable?
- Which Parts of a Car Accident Settlement Are Not Taxable?
- Are Punitive Damages Taxable?
- What Does the IRS Say About Personal Injury Settlements?
- Does California Tax Car Accident Settlements Differently?
- How to Reduce Taxes on a Car Accident Settlement
- Do You Have to Report a Car Accident Settlement on Your Tax Return?
- When to Contact a Car Accident Attorney
- FAQs
Which Parts of a Car Accident Settlement Are Taxable?
Some parts of settlements in car accident claims are treated as ordinary income by the Internal Revenue Service and thus there are tax consequences associated with them.
These parts of settlements include:
Compensation for Emotional Distress Not Directly Related to Physical Harm
Compensation for emotional distress without any physical harm is fully taxable.
The IRS and courts draw a clear line. Emotional distress without physical injury is taxable. Emotional distress caused by a physical injury is not taxable.
Compensation for Lost Wages Not Directly Related to Physical Harm
Some lost wages included in a settlement may be taxable, particularly if they push you into a higher tax bracket because of the amount received.
Compensation for lost wages caused by a car accident may be taxable if the lost wages are not directly related to physical injuries. The IRS taxes income that would have otherwise been earned in this scenario.
Examples of compensation for lost wages that are taxable include compensation for wages lost due to the loss of use of a vehicle and compensation for wages lost due to business disruption without bodily harm.
Interest Accrued
Interest accrued on verdicts or settlements are fully taxable.
Legal Fees
Prior to 2017, plaintiffs could commonly deduct attorney fees regarding taxable settlements. However, the Tax Cuts and Jobs Act largely got rid of these deductions in personal injury cases.
If part of your settlement ends up being taxable, like interest or punitive damages, you could be able to deduct attorney fees as a miscellaneous itemized deduction. However, this is subject to specific IRS rules.
The IRS requires that insurers issue Form 1099 regarding certain payments made in settlements. This can include attorney fees when they are part of a taxable settlement.
Punitive Damages
Punitive damages which are awarded in a settlement are subject to income tax. They must be reported as ‘other income’ on a tax return per IRS Publication 4345.
These are reported on Form 1040.
Medical Expenses Previously Deducted on a Tax Return
Medical expenses that are reimbursed through a settlement are taxable when you previously deducted those expenses on your taxes.
Which Parts of a Car Accident Settlement Are Not Taxable?
Most parts of car accident settlements are not taxable.
Parts of car accident settlements which are not taxable include:
Compensation for Physical Injury and Physical Sickness
According to the IRS, damages which are received for physical sickness or personal physical injuries are typically excluded from gross income. This means they are not taxable.
This includes compensation for:
- Medical expenses: Emergency care, surgery, diagnostics, physical therapy, prescriptions and medical devices, as long as these costs were not previously deducted on a tax return.
- Lost wages and income: Lost wages and income directly resulting from physical injuries or disability caused by an accident. These lost wages can be excluded from gross income according to Rev. Rul. 85-97.
- Pain and suffering: Physical pain, mental suffering, emotional distress and lost quality of life caused by documented physical injuries.
- Long-term disability: Long-term income loss resulting from a disability caused by a physical injury sustained in an accident.
Compensation for Property Damage
Compensation for property damage isn’t taxable. It is considered reimbursement for loss of value instead of taxable income.
Payouts to replace personal items or repair your vehicle are non-taxable returns of capital.
However, if an insurance company’s payout for a totaled car is larger than the vehicle’s adjusted tax basis, any excess amount may technically be taxed as a capital gain.
Most Compensation in Wrongful Death Claims
Most compensation in wrongful death claims is not taxable.
However, there are some exceptions, such as punitive damages, medical expenses that were previously deducted on an earlier tax return, and interest earned.
Are Punitive Damages Taxable?
Yes. Punitive damages are taxable under federal law regardless of case type.
Punitive damages do not compensate plaintiffs for losses. They punish defendants for egregious conduct.
Punitive damages must be reported as “other income” on Form 1040 per IRS Publication 4345.
Punitive damages are not commonly awarded in car accident cases. However, they may be awarded when drivers were intoxicated, acted recklessly or intentionally caused harm.
Punitive awards can be large and can push claimants into higher tax brackets. Structured, periodic payments are thus often advisable.
What Does the IRS Say About Personal Injury Settlements?
The IRS closely looks at your settlement agreement’s explicit wording to determine tax implications.
26 U.S. Code § 104(a)(2) is the controlling federal statute here. Compensation received “on account of personal physical injuries or physical sickness” are excluded from gross income.
This exclusion applies to lump-sum payments as well as periodic structured payments.
The threshold requirement is “physical injury.” Most damage categories become taxable without it.
The IRS will typically not disturb settlement allocations that are consistent with the injuries and claims that are actually at issue, per IRS guidance and case law. For example, large allocations for pain and suffering regarding catastrophic injuries are defensible. Outsized allocations for minor fender bender accidents are not.
The insurer may issue an IRS Form 1099. This does not mean the full amount is taxable. Consult with a tax professional to determine what to report.
Does California Tax Car Accident Settlements Differently?
No. California does not impose any additional state income tax on personal injury settlements beyond what is already taxed by the IRS.
The Franchise Tax Board (FTB) typically follows federal law. What is tax-exempt under federal law is tax-exempt under California law when it comes to personal injury settlements.
California residents should confirm their specific situation with a professional tax advisor. State rules can interact with other income in complex ways.
How to Reduce Taxes on a Car Accident Settlement
Structured settlements may be more favorable regarding long-term financial planning, particularly when large sums are involved. They could help manage tax liabilities over time, helping you to avoid paying taxes.
Lump-sum settlements may increase your tax liability in a single year. This can potentially push you into a higher tax bracket. Structured payments may help mitigate this effect by spreading any income over several years.
Structure your settlement intentionally. The IRS will honor allocations that are reasonable relative to the injuries and claims involved.
Direct as much of the settlement as is legitimately possible towards non-taxable categories such as medical expenses, property damage and pain and suffering caused by physical injury.
Spread taxable payments over multiple years via a structured settlement. A $100,000 punitive damage award paid at one time may push a single filer into a higher tax bracket. The same amount paid over five years at $20,000 per year may reduce the tax burden by keeping the filer at a lower tax bracket.
Properly structured periodic payments from physical injury settlements remain tax-free per IRC § 130.
Avoid deducting medical expenses in the same year that a non-taxable settlement is expected. You may make that reimbursement taxable under the tax benefit rule by doing so.
Work with an attorney before you sign any settlement documents. The IRS’s interpretation will be based upon the agreement’s allocation language.
Do You Have to Report a Car Accident Settlement on Your Tax Return?
It is required by the IRS that you report any settlement over $600 that contains taxable components using Form 1099-NEC or 1099-MISC.
Non-taxable settlement proceeds do not need to be reported on a federal income tax return.
Taxable portions must be reported. For example, punitive damages go on Form 1040 as “other income.”
The full amount is not automatically taxable if an insurer issues a 1099 for the full settlement amount. A tax professional can help you identify what portions are excludable.
The failure to report taxable amounts can lead to IRS penalties and interest.
When to Contact a Car Accident Attorney
Call an experienced personal injury lawyer at our firm today for a FREE consultation at (800) 718-4658 or contact us if you or a loved one was injured or killed in a car accident.
We can help you recover financial compensation for your injuries and we will charge you no legal fee until we win your case.
Call us today.
FAQs
Are Car Insurance Payouts for Property Damage Taxable?
Not generally. Property damage reimbursement is usually not taxable because it compensates for a loss in value rather than income.
An exception is if the payout exceeds the vehicle’s adjusted basis, or original cost minus depreciation. The excess may be treated as a capital gain in this case.
Are Pain and Suffering Settlements Taxable in California?
Compensation for pain and suffering is not taxable when the pain and suffering was caused by a physical injury sustained in an accident.
The IRS may treat compensation for emotional distress or psychological harm as taxable income if the emotional distress or psychological harm was not caused by a physical injury.
Can the IRS Take My Settlement Check?
Yes.
The IRS may seize your settlement, even if your settlement is not taxable, if:
- You owe back taxes
- You are behind on government-related debts such as student loans
- You have unpaid child support
They can claim your settlement via:
- Tax liens
- Offsetting government benefits such as Social Security
- Levies and garnishments
Are All Car Accident Settlements Taxable?
No. In fact, most parts of car accident settlements are not taxable. Some parts, however, are.
