After fighting for fair compensation following an injury, the last thing you want is an unexpected tax bill. Many West Texans who receive personal injury settlements are surprised to learn that certain portions of their compensation may be taxable.
At Keith & Lorfing, we’ve seen clients struggle with the complex tax implications of their settlements, often learning about potential tax liability after it’s too late to structure their settlement advantageously.
This guide explains which parts of your Texas personal injury settlement may be subject to taxation, what exceptions exist, and how our knowledgeable attorney will help you minimize your tax burden.
Injured in West Texas? Speak with our experienced Abilene personal injury lawyer today to explore your legal options and pursue the compensation you deserve.
Are Personal Injury Settlements Taxable in General?
Personal injury settlements compensate individuals harmed due to another party’s negligence or wrongful actions. These settlements typically cover medical expenses, lost wages, pain and suffering, and property damage.
đŸ’¡ Tax laws favor restoring what you’ve lost, not rewarding you — but knowing the fine line early can prevent future IRS scrutiny.
As a general rule, the Internal Revenue Service (IRS) considers personal injury settlements for physical injuries or physical sickness to be non-taxable. This tax exclusion stems from the principle that these payments are meant to make you “whole” again—not to enrich you beyond your pre-injury state.
However, this tax-free status doesn’t apply to all elements of a settlement.
The Critical Distinction: Compensatory vs. Punitive Damages
Personal injury settlements typically contain two main types of damages:
| Type of Damages | Primary Purpose | Taxable Status |
|---|---|---|
| Compensatory | To reimburse for actual losses | Generally non-taxable for physical injuries |
| Punitive | To punish the defendant for egregious behavior | Always taxable |
Compensatory damages are designed to restore what you lost due to your injury. These include medical expenses, lost wages, and compensation for pain and suffering directly related to physical injuries.
Punitive damages, however, aren’t meant to compensate you but rather to punish the wrongdoer and deter similar conduct in the future. Because they represent a windfall beyond what’s necessary to make you whole, the IRS treats punitive damages as taxable income.
What Parts of a Personal Injury Settlement Are Taxable?
Knowing which portions of your settlement may be subject to taxation is essential for proper financial planning.
| Settlement Component | Typically Taxable? | Key Considerations |
|---|---|---|
| Medical Expenses | Generally No | Exception: If you previously deducted these expenses on your tax return, the deducted amount becomes taxable if later compensated |
| Lost Wages | Yes | The IRS views this as a replacement for income you would have earned and paid taxes on |
| Pain and Suffering | Generally No | Must stem directly from a physical injury or physical sickness |
| Emotional Distress | It depends | Not taxable if resulting from physical injury (e.g., PTSD after accident). Taxable if not tied to physical injury |
| Property Damage | Generally No | Exception: If compensation exceeds your property’s adjusted basis, the excess may be taxable as capital gain |
| Punitive Damages | Always Yes | Taxable regardless of whether awarded in a physical injury case, as they do not relate to your actual losses or chances of winning a lawsuit. |
| Interest on Settlement | Always Yes | Any interest accrued is taxable as interest income, even if the underlying settlement is tax-free. |
Hypothetical Example: Consider a situation where, in 2022, a person named Maria deducted $15,000 in medical expenses related to her car accident. In 2023, she hypothetically received a settlement that included $20,000 for those medical expenses. In this scenario, Maria would need to report the $15,000 she previously deducted as taxable income on her 2023 tax return, while the additional $5,000 would remain tax-free.
Are Personal Injury Settlements Taxable in Texas?
While many aspects of personal injury law vary by state, taxation of settlements is primarily governed by federal law. That said, Texas residents have one significant advantage:
Texas has no state income tax.
This means you won’t pay state income tax on any portion of your settlement. However, federal tax laws still apply to Texas residents, so you may still owe federal taxes on certain portions of your settlement.
As Russell Lorfing often reminds our clients, “Living in Texas means you’re already ahead of the game when it comes to settlement taxation, but don’t make the mistake of thinking you’re completely in the clear with the IRS.”
đŸ“Œ Texas may not take a cut, but your zip code doesn’t shield you from federal tax consequences — location affects perception, not IRS rules.
What the IRS Says About Settlement Taxability
The taxation of personal injury settlements is primarily governed by Section 104(a)(2) of the Internal Revenue Code. This section specifies that damages (other than punitive damages) received on account of personal physical injuries or physical sickness are excluded from gross income.
According to the IRS, the following situations would trigger taxation:
- You receive punitive damages
- You receive compensation for emotional distress not stemming from a physical injury
- You receive interest on a settlement
- You previously deducted medical expenses that were later compensated in a settlement
- You receive compensation for lost wages or business profits
Practical Scenarios of Taxable and Non-Taxable Settlements
Let’s look at some hypothetical examples to better understand how taxation might apply to different settlement scenarios.
Hypothetical Example 1: Car Accident Settlement
Consider John, who was hypothetically injured when another driver ran a red light in Abilene. His settlement might include:
| Settlement Component | Amount | Taxable? |
|---|---|---|
| Medical expenses | $50,000 | No (assuming no prior deduction) |
| Lost wages | $25,000 | Yes |
| Pain and suffering | $35,000 | No (stems from physical injury) |
| Punitive damages | $10,000 | Yes |
| Total Settlement | $120,000 | $35,000 taxable |
In this hypothetical scenario, John would need to report $35,000 of his settlement as taxable income on his federal tax return.
Hypothetical Example 2: Slip and Fall with Emotional Distress
Imagine Sarah, who hypothetically slipped on a wet floor at a store in Lubbock, resulting in a broken hip. Her settlement might include:
| Settlement Component | Amount | Taxable? |
|---|---|---|
| Medical expenses | $30,000 | No |
| Emotional distress | $15,000 | No (stems from physical injury) |
| Lost wages | $5,000 | Yes |
| Total Settlement | $50,000 | $5,000 taxable |
In this hypothetical case, only $5,000 of Sarah’s settlement would be considered taxable income.
How to Minimize the Taxes You Owe on a Settlement
Work with a Tax Attorney or CPA
Consult with our qualified tax professional before finalizing your settlement. Our tax attorney or CPA with experience in personal injury settlements will help structure your settlement to minimize tax liability and maximize your chances of winning.
As Trey Keith, founding partner at Keith & Lorfing and one of our experienced West Texas trial attorneys, emphasizes: “The time to think about taxes is before you sign the settlement agreement, not after the check arrives.”
Structure Your Settlement Agreement
The language in your settlement agreement matters significantly. Working with both our personal injury attorney and our tax professional, you can structure the allocation of damages to maximize non-taxable components.
For example:
- Clearly specify which portions are for physical injuries
- Explicitly allocate amounts to medical expenses
- Separate compensation for emotional distress related to physical injuries from other forms of compensation
đŸ’¡ Tax-smart planning isn’t just about saving money — it’s about preserving the purpose of your compensation over time.
Consider a Structured Settlement
Rather than receiving a lump sum, consider a structured settlement that pays out over time. This approach can:
- Spread out taxable income over multiple tax years
- Potentially keep you in a lower tax bracket
- Provide financial security over a longer period
Understand 1099 Reporting Responsibilities
The defendant or insurance company paying your settlement may be required to issue a 1099-MISC form for taxable portions of your settlement. Knowing what will be reported to the IRS allows you to properly prepare your tax returns.
Have questions about your case? Contact us for a free consultation—our legal team is here to help, day or night.
Common Misconceptions About Taxing Settlements
- All Settlements Are Tax-Free:Â One of the most dangerous misconceptions is that all personal injury settlements are completely tax-free. Several components of a settlement may be taxable, particularly punitive damages and compensation for lost wages.
- If I Live in Texas, I Don’t Owe Any Tax: While Texas residents don’t pay state income tax, federal taxes still apply to taxable portions of settlements. The IRS doesn’t care whether your state has an income tax—federal tax laws apply equally across all states.
- I Can Just Hide the Settlement from the IRS:Â This is not only incorrect but potentially criminal. Large settlements are typically reported to the IRS by the paying party. Failing to report taxable settlement income could result in audits, penalties, and even criminal charges for tax evasion.
Hypothetical Case Scenario: Strategic Settlement Structuring
Let’s consider how proper settlement structuring could benefit someone in West Texas. Imagine a 45-year-old oilfield worker from Midland who suffered serious injuries when a piece of equipment malfunctioned. His initial settlement offer might include:
- $200,000 for medical expenses
- $150,000 for lost wages
- $100,000 for pain and suffering
- $50,000 in punitive damages
With proper legal assistance and tax consultation, this hypothetical settlement could potentially be restructured to:
- $220,000 for medical expenses
- $100,000 for pain and suffering
- $100,000 for future medical treatment
- $80,000 for lost wages
- $0 in punitive damages (negotiated out in exchange for higher compensatory damages)
This type of restructuring could significantly reduce potential tax liability while maintaining the same total settlement amount. This is one way our attorneys at Keith & Lorfing work to maximize client outcomes when structuring settlements.
Do You Pay Taxes on Attorney Fees from a Settlement?
Attorney fees present another tax complication. In many personal injury cases, attorneys work on a contingency fee basis, typically taking 30-40% of the settlement as their fee.
đŸ“Œ The moment before you sign is your last chance to change the tax impact — where you turn next determines how much of your settlement you keep.
According to the IRS, you must generally report the entire settlement as income (for the taxable portions), even the percentage that goes directly to your attorney. You may then be able to deduct the attorney fees, but tax law changes have made these deductions more limited in recent years.
The 2017 Tax Cuts and Jobs Act eliminated miscellaneous itemized deductions, which previously allowed some plaintiffs to deduct attorney fees. Now, in many non-physical injury cases, plaintiffs might face taxes on 100% of their settlements while only receiving 60-70% after attorney fees.
For personal physical injury cases where the underlying settlement is tax-free, the portion paid to attorneys would also be tax-free.
Final Thoughts: Get Legal & Tax Help Before Accepting a Settlement
The taxation of personal injury settlements is complex, with rules that can seem counterintuitive. Before finalizing any settlement agreement, we strongly recommend consulting with both our personal injury attorney experienced in settlement structuring and our qualified tax professional.
At Keith & Lorfing, we work with our clients to maximize their after-tax recovery. We can help you understand the potential tax implications of your settlement and connect you with qualified tax professionals who understand the unique aspects of personal injury settlements in Texas.
Don’t risk unexpected tax liabilities or IRS penalties. Call us today at (325) 246-9410Â or contact us online for a free consultation about your case and how we will help protect your settlement from unnecessary taxation.
FAQ
Is a personal injury settlement considered income by the IRS?
It depends on the type of damages. Compensation for physical injuries or sickness is generally not considered taxable income. However, punitive damages, interest on settlements, compensation for emotional distress not stemming from physical injury, and certain other portions may be considered taxable income.
Are lost wages in a personal injury settlement taxable?
Yes, compensation for lost wages is typically taxable because it replaces income you would have earned (and paid taxes on) if not for your injury.
What types of settlement compensation are always taxed?
Punitive damages and interest earned on settlements are always taxable, regardless of whether they stem from a physical injury case.
Does Texas tax any part of a personal injury settlement?
No. Texas has no state income tax, so you won’t pay state taxes on your settlement. However, federal tax laws still apply to Texas residents.
Do I need to report a personal injury settlement to the IRS?
Yes, you should report your settlement to the IRS, even if you believe it’s entirely non-taxable. Taxable portions must be included as income on your federal tax return. The proper reporting methods depend on the nature of your settlement and should be discussed with our tax professional.
