Are car accident settlements taxable?

The basic rule: physical injury damages are not income#

The federal tax code sets the starting point: Damages (other than punitive damages) received on account of personal physical injuries or physical sickness are excluded from gross income. The exclusion applies whether paid after a lawsuit or by agreement, and as a lump sum or as periodic payments, so a structured settlementStructured settlement. A settlement paid as a series of future payments, often funded by an annuity, instead of one lump sum. The amounts and dates are fixed when the settlement is signed. Glossary paid over many years is treated the same way as a single check.

The IRS guide to settlements, IRS Publication 4345, Settlements—Taxability (Rev. 9-2023), puts it simply. If you receive a settlement for personal physical injuries or physical sickness, and you did not deduct related medical expenses in earlier years, the full amount is not taxable, and you do not include it in your income.

For a typical injury claim after a crash, that usually covers money for medical bills, for pain and suffering caused by the injury, and for emotional distress that comes from the physical injury. Our guide to types of damages explains each category.

What can be taxable#

Punitive damages

Punitive damagesPunitive damages. Extra damages meant to punish very bad conduct, not to repay a loss. Many states cap them; Texas calls them exemplary damages. Glossary punish very bad conduct rather than repay a loss, and they are awarded only in some cases. The physical injury exclusion leaves them out on purpose, so they are taxable, even when they are part of a settlement for a physical injury.

Emotional distress

The tax code says that, for the injury exclusion, emotional distress is not treated as a physical injury or physical sickness. In practice, the IRS treats distress that flows from a physical injury in the crash like the injury itself. If you were not physically hurt, for example if your claim is only for the shock of a near miss, damages for distress are taxable, except amounts for related medical expenses you did not deduct earlier.

Lost wages and lost profits

Lost wages need a closer look. IRS Publication 525 lists lost wages and lost profits as income "in most cases", and in the same section tells taxpayers not to include compensatory damages for personal physical injury. The taxable examples in Publication 4345 come from employment lawsuits, where lost wages are taxable wages, subject to social security and Medicare taxes, and from business claims, where lost profits are taxable business income, subject to self-employment tax. If your settlement includes money for missed work or a business, a tax professional can tell you how that part is treated. See our guide to lost wages for how the claim itself works.

Medical expenses you deducted earlier#

If you itemized deductions in an earlier year and deducted crash-related medical bills, part of the settlement may become taxable. Money that repays those expenses is taxable to the extent the earlier deduction gave you a tax benefit. If the expenses were spread over more than one year, Publication 4345 says the amount must be divided among those years in proportion; Publication 525 explains the calculation under "Recoveries".

Property damage settlements#

Money for a damaged car is not an injury payment, so different rules apply. According to Publication 4345, a settlement for loss in value of property is not taxable up to your adjusted basis in the property, which the settlement reduces; any amount above basis is income. Your adjusted basisAdjusted basis. For tax purposes, generally what you paid for property, plus improvements, minus certain deductions such as depreciation. It is used to work out whether money for property is taxable. Glossary is generally what you paid for the property, adjusted for certain items. Our guide to property damage and diminished value explains how the car claim itself works.

How the settlement is divided#

A settlement can cover several kinds of damages at once, and the agreement may say how the money is split among them. The IRS generally will not disturb an allocation that is consistent with the substance of the settled claims. This is one reason the wording of the settlement agreement can matter for taxes, and you may want to ask a tax professional to review it before you sign.

Lawyer's fees and the taxable part#

For the tax-free part of an injury settlement, the lawyer's contingency fee does not usually create a tax issue. For any taxable part, it can. Publication 525 says attorney fees and costs are counted as ordinary income when the underlying recovery is taxable, including contingent fees.

In other words, if part of a recovery is taxable, such as punitive damages or interest, the lawyer's share of that part may count as your income even though it was paid to the lawyer. Publication 525 describes a deduction for such fees only for certain kinds of claims, such as unlawful discrimination claims. A tax professional can tell you whether any deduction applies to you.

Forms 1099 and reporting#

A business that pays you taxable damages, such as punitive damages, of $2,000 or more in a year generally reports them on Form 1099-MISC, in box 3. The IRS instructions tell payers that damages (other than punitive damages) received on account of personal physical injuries or physical sickness are not reported, so the tax-free part of an injury settlement does not belong on the form.

When an insurer pays a settlement to your lawyer, it may also report the payment to the lawyer as gross proceeds in box 10 of Form 1099-MISC, at $600 or more. That form is about the payment to the lawyer.

Two more points from Publication 4345:

• Estimated tax. If a taxable settlement means you expect to owe $1,000 or more after credits and withholding, you may need to make estimated tax payments.
• Health coverage. If you get advance premium tax credits through the Health Insurance Marketplace, a taxable settlement that raises your income is a change to report to the Marketplace.

State income tax rules can differ from the federal rules described here, so check your state's rules as well.