Are you:
- Thinking about bringing a personal injury claim?
- Negotiating your personal injury settlement?
- About to collect your settlement award?
Then, you need to know if personal injury settlements are taxable in NC.
Horton & Mendez Injury Attorneys explain personal injury settlements and North Carolina tax law.
Do You Pay Taxes on Personal Injury Settlements in North Carolina?
Most funds awarded in a personal injury settlement in North Carolina are not taxed. Amounts awarded for compensatory damages like medical bills and pain and suffering are not taxed.
Punitive damages, if awarded, are subject to tax. Interest paid is also taxable. Because North Carolina income rules mirror U.S. federal tax law, most personal injury settlement funds are not taxed federally or by the state.
What Parts of a Personal Injury Settlement Are Tax-Free?
- Medical bills (past and future)
- Lost wages, damaged career path
- Property damage
- Pain and suffering
- Emotional anguish
- Loss of consortium
Generally, compensatory damages are not taxed as part of a personal injury settlement. This includes economic and non-economic damages.
Why aren’t compensable damages taxed for personal injury?
Compensable damages make you whole for losses you have due to a personal injury. For example, if you have a $10,000 medical bill, you may receive $10,000 in compensation. If you had to pay a 15% tax on that amount, effectively, you would only receive $8,500. You would still have to pay the remaining $1,500 to fully pay the bill. Compensatory damages couldn’t properly make you whole if they were subject to tax. Because compensable damages are not income, they’re not taxed.
Rule for Personal Injury Settlement Tax in NC
IRS Code § 61 defines income. Usually, income includes gross income from any source, including compensation for services. 26 U.S.C. § 104(a)(2) clarifies that gross income does not include amounts received as compensation for personal injury.
Most parts of a personal injury settlement are compensation for the injury. Only punitive damages and interest are not compensatory and subject to tax.
North Carolina tax law for personal injury settlements
North Carolina income tax laws mirror federal tax laws. N.C.G.S. § 105-130.2 says that gross income for state tax purposes is derived from § 61 of the IRS code. The rule is the same for federal and NC state tax—personal injury settlements for compensatory damages are not income.
When Can a Personal Injury Settlement Be Taxed in NC?
There are three situations where a personal injury settlement may be subject to tax in NC:
Punitive damages
Punitive damages punish the wrongdoer for extremely egregious conduct. They are paid to the plaintiff who brings the claim. Punitive damages don’t reflect a loss that the victim has. For that reason, they are subject to tax. Although they are not often awarded, when they do apply, punitive damages can be a significant amount. Plan for taxes if you receive a punitive damages award.
Interest income
Pre-judgment or post-judgment interest is subject to tax.
Medical bills previously deducted
If you deducted medical bills in a prior year and you are now compensated for the same bills, you may need to report the amount as income for tax purposes.
Lost Wages and NC Income Tax
No, personal injury settlement amounts awarded for lost wages are not subject to tax in North Carolina.
There is a lot of confusion about this topic. Perhaps that’s because it might seem like lost wages should be subject to tax. After all, it would be taxed as income if you had earned it.
However, and fortunately for personal injury victims, that’s not how the IRS sees it.
The IRS says that even when the award is for lost wages, it is still compensation for personal injury. And that’s true—lost wages are compensatory damages.
If lost wages were taxed, it could result in an unfair scenario for the injured person. Since a personal injury settlement is often awarded in a lump sum, taxing the funds could result in a higher overall tax burden than if a person paid taxes on the same amount in several years over time. But because lost wages aren’t taxed at all, this isn’t a problem.
Employment and other non-injury lawsuits
The tax-free rule for lost wages applies to personal injury lawsuits only. If a claim is employment-related, then lost wages are likely subject to tax. Different types of lawsuits are treated differently when it comes to how lost wages are taxed. They are tax-free for personal injury claims.
Law for whether lost wages are subject to tax for personal injury claims
IRS Rev. Rul. 85-97 says that the entire amount paid in compensation for a personal injury, including the amount allocable for lost wages, is excluded from gross income. See also Commissioner v. Schleier, 515 U.S. 323, 329-30 (1995).
Can attorney fees from a personal injury settlement be deducted from taxable income?
No. Attorney fees are not deductible for income tax purposes. Even if they’re deducted before you receive your award, they’re not a deduction for tax purposes. However, this usually applies in the case of a contingency fee award or interest income. It is unlikely that the amount of attorney fees would exceed the award. See Commissioner v. Banks, 543 U.S. 426 (2005).
How To Minimize Tax Liability on Your Settlement
At all stages of your case, be mindful of the possibility of tax liability on your settlement. If the IRS questions your award, they will look at the circumstances to determine the true nature of the award.
For example, say you are awarded $100,000 in compensatory damages at trial and $300,000 in punitive damages. Then, the defense appeals the award. While on appeal, you settle the case for $250,000, calling it all compensatory. The IRS may say that the entire settlement can’t be called $250,000 because of the trial verdict.
It’s important to be aware of the possibility of tax liability as you strategize at all stages of your case.
Contact an Experienced Apex Personal Injury Lawyer
Do you have questions about how a personal injury settlement may be taxable in your NC personal injury case? We invite you to contact Horton & Mendez Injury Attorneys.
