Are Personal Injury Settlements Taxable?
Brian Davidson

If you have a personal injury claim in Alabama or Florida, one of the first questions that may come to mind is how much of a bite will the government take out of a settlement in taxes. Say it with me, "It depends." It depends on how the compensation is categorized. While many personal injury settlements are not subject to federal income tax, certain portions may still be taxable depending on the details of your case. You should always consult with counsel and a tax professional!!!

Federal tax law drives the answers to these questions.

 

IRC § 104(a)(2) excludes damages received "on account of personal physical injuries or physical sickness," against the default that all income is taxable under § 61. (26 U.S.C.A. § 104 (West)) (26 U.S.C.A. § 61 (West)) The Supreme Court's two-part test and "on account of" causation standard decide, element-by-element, which portions of a recovery are excludable. (Comm'r v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L. Ed. 2d 294 (1995)) (O'Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L. Ed. 2d 454 (1996))

 

How different types of damages are treated for tax purposes (in a nutshell):

The state layer is straightforward. Alabama reaches the federal result by cross-referencing § 104 directly and otherwise taxing income "from any source whatever." (Ala. Code § 40-18-14) (Ala. Code § 40-18-14) Florida imposes no individual income tax, so none of these premises carries a Florida state income tax consequence for an individual. (Fla. Const. art. VII, § 5).

 

Compensation tied directly to physical injuries or sickness (medical bills, physical pain, losses from a bodily injury) is generally not taxable.

 

Federal. IRC § 104(a)(2) excludes damages received “on account of personal physical injuries or physical sickness.” (26 U.S.C.A. § 104 (West)) The implementing regulation restates this exclusion and defines “damages” to include amounts received “through a settlement agreement entered into in lieu of prosecution.” (26 C.F.R. § 1.104-1) The Supreme Court has set a two-part test: the recovery must arise from “tort or tort type rights,” and the damages must be received “on account of personal injuries or sickness.” (Comm’r v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L. Ed. 2d 294 (1995)) Illustrating the exclusion, the Court explained that where a taxpayer is injured in an auto accident, the portions of a settlement compensating medical expenses, pain and suffering, and injury-related lost wages are all excludable because each element is received “on account of” the physical injury. (Comm’r v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L. Ed. 2d 294 (1995))

Alabama. Alabama excludes the identical category by incorporating § 104. (Ala. Code § 40-18-14) The Department of Revenue regulation confirms the exclusion for “[a]mounts received which are excludable from gross income under 26 U.S.C. § 104 (26 U.S.C.A. § 104 (West)), relating to compensation for injuries or sickness.” (Ala. Admin. Code 810-3-14-.02)

 

 

The purpose of the payment controls; the manner of resolution (negotiation vs. court) does not change the result.

 

Federal. The statute expressly applies “whether by suit or agreement,” so the method of resolution is immaterial. (26 U.S.C.A. § 104 (West)) The regulation likewise reaches amounts received “through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.” (26 C.F.R. § 1.104-1) As to purpose, the Supreme Court grounds the exclusion in a restorative rationale: it covers damages that, “making up for a loss, seek to make a victim whole,” or “return the victim’s personal or financial capital,” and it turns on whether each element is received “on account of” — “by reason of, or because of” — the injury, not merely because it was paid in a personal injury matter. (O’Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L. Ed. 2d 454 (1996)) Because the analysis is element-by-element and driven by what each payment compensates, how the case resolved is not the operative question. (Comm’r v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L. Ed. 2d 294 (1995))

Alabama. The result follows federal characterization through the § 104 cross-reference, (Ala. Code § 40-18-14) which the regulation directs be interpreted consistently with federal law. (Ala. Admin. Code 810-3-14-.02)

 

 

Punitive damages are typically taxable because they punish rather than compensate.

 

Federal. Section 104(a)(2) excludes damages “other than punitive damages” on its face. (26 U.S.C.A. § 104 (West)) The Supreme Court held that punitive damages in a tort suit for personal injuries were not received on account of personal injuries; hence the provision does not apply, and the damages are taxable. (O’Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L. Ed. 2d 454 (1996)) The Court reasoned that such damages “are not compensation for injury” but “private fines levied by civil juries to punish reprehensible conduct and to deter its future occurrence,” and so are “not a substitute for any normally untaxed personal (or financial) quality, good, or ’asset” and do not compensate for any kind of loss. (O’Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L. Ed. 2d 454 (1996)) Congress confirmed this treatment through the 1996 Small Business Job Protection Act, which explicitly excepts most punitive damages from the exclusion provided by § 104(a)(2). (O’Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L. Ed. 2d 454 (1996))

Alabama. Punitive damages are not excludable under § 104, so they fall within Alabama’s broad “income derived from any source whatever” definition and are taxable. (Ala. Code § 40-18-14)

 

 

Interest on a settlement or judgment is usually taxable, even if the underlying recovery is not

 

Federal. Interest components are taxable because they do not restore lost human or financial capital. The Fifth Circuit held that prejudgment interest in a personal injury suit “constitutes gross income, and is therefore taxable unless it comes within an exclusion,” (Chamberlain ex rel. Chamberlain v. United States, 401 F.3d 335 (5th Cir. 2005)) and found it is not excludable: it “lacks the direct relationship to personal injury necessary to meet the second prong of the (Comm’r v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L. Ed. 2d 294 (1995)) test as described by (O’Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L. Ed. 2d 454 (1996)),” because it “compensates an individual for his lost time value of money” rather than restoring the injured party’s “personal or financial capital.” (Chamberlain ex rel. Chamberlain v. United States, 401 F.3d 335 (5th Cir. 2005)) The court noted its holding aligns with the First, Third, and Tenth Circuits. (Chamberlain ex rel. Chamberlain v. United States, 401 F.3d 335 (5th Cir. 2005))

Alabama. Interest is not within § 104, so it is taxable in Alabama under the general definition. (Ala. Code § 40-18-14) The Department of Revenue regulation separately confirms that interest income — including interest from the federal government, such as interest on tax refunds — “is subject to Alabama income tax and should be included in gross income.” (Ala. Admin. Code 810-3-14-.02)

 

 

Emotional distress damages are taxable unless connected to a physical injury

 

Federal. The flush language of § 104(a) provides that “[f]or purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness,” subject to a narrow carve-out for damages not exceeding amounts paid for related medical care. (26 U.S.C.A. § 104 (West)) The regulation restates this: “Emotional distress is not considered a physical injury or physical sickness,” but “damages for emotional distress attributable to a physical injury or physical sickness are excluded,” as are damages up to amounts paid for medical care for emotional distress. (26 C.F.R. § 1.104-1) Applying this, the D.C. Circuit held that compensatory damages for emotional distress and loss of reputation in a non-physical-injury action were “not”received … on account of personal physical injuries”” and were includable in gross income under § 61. (Murphy v. I.R.S., 493 F.3d 170 (D.C. Cir. 2007)) This “physical” requirement derives from the 1996 Small Business Job Protection Act amendment. (26 C.F.R. § 1.104-1)

Alabama. Emotional-distress recoveries tied to a physical injury track the federal exclusion via the § 104 cross-reference; (Ala. Code § 40-18-14) those not tied to a physical injury are not excludable and are taxable under Alabama’s general definition. (Ala. Code § 40-18-14)

 

 

Prior medical-expense deductions can make a later reimbursement taxable (anti-double-benefit rule)

 

Federal. Section 104(a) opens with an express carve-out: the exclusion applies except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year. (26 U.S.C.A. § 104 (West)) This dovetails with the tax-benefit rule of IRC § 111(a), under which gross income “does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed” — the corollary being that a reimbursement of prior-year medical expenses that did produce a tax benefit is included in income. (26 U.S.C.A. § 111 (West)) The Supreme Court acknowledged this limitation in its illustration, noting the full settlement is excludable only “if the taxpayer has not previously deducted her medical expenses.” (Comm’r v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L. Ed. 2d 294 (1995))                                                                                                                                                                                                                                                                                              Alabama. Because the § 104 exclusion — including its § 213-deduction carve-out — is incorporated by cross-reference, a reimbursement that is taxable federally under this rule is likewise outside the Alabama exclusion and taxable. (Ala. Code § 40-18-14)

 

 

The settlement’s structure and allocation of damages affect tax treatment.

 

Federal. Tax treatment is determined element-by-element, so how a settlement characterizes and allocates its components matters. The Supreme Court held that “each element of the settlement” is excludable only where “each element …satisfies the requirement …that the damages were received ’on account of personal injuries or sickness,” not simply because the taxpayer received a tort settlement. (Comm’r v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L. Ed. 2d 294 (1995)) The “on account of” standard requires a strong causal link — damages awarded “by reason of, or because of, the personal injuries” — which must be assessed for each portion of a recovery. (O’Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L. Ed. 2d 454 (1996)) The interest cases apply the same component-by-component analysis, separating taxable interest from excludable injury compensation within a single award. (Chamberlain ex rel. Chamberlain v. United States, 401 F.3d 335 (5th Cir. 2005))

Alabama. Alabama follows the same characterization because it incorporates § 104 and directs federal-consistent interpretation; (Ala. Admin. Code 810-3-14-.02; Ala. Code § 40-18-14) components that do not qualify under § 104 remain within the “any source whatever” base. (Ala. Code § 40-18-14)

 

If you have questions about a personal injury settlement or want to better understand your legal options, we are here to help. We offer flexible options to connect, including in-office, phone, and virtual meetings, so you can speak with a free consultation lawyer serving Alabama and Florida at your convenience.

Understanding your settlement is just as important as securing it. With the right guidance, you can move forward with confidence and peace of mind.