By David Goguen , J.D. University of San Francisco School of Law
Updated by Dan Ray , Attorney University of Missouri–Kansas City School of Law
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The main IRS rules on the taxability of personal injury settlements and judgments are found in 26 U.S.C. § 104(a)(2) (2024). Here, in a nutshell, is the bottom line: Amounts you receive as compensatory damages for personal physical injuries or physical sickness are excluded from your taxable income—meaning they're not taxable by the federal government.
Note that these rules apply to personal injury settlements generally, not just to those involving auto accidents.
When you win a typical car accident case, you'll recover what the law calls "compensatory damages." These personal injury damages fall into two categories.
Punitive damages don't compensate you for your injuries. Instead, they punish a wrongdoer for extreme and outrageous misconduct. Because they don't compensate you for your injuries, they're not excluded from your taxable income. Stated more directly, punitive damages are taxable.
Punitive damages are rare in car accident cases. Chances are you won't need to worry about these tax consequences.
Only compensatory damages that are paid to you for physical injuries or physical sickness can be excluded from your federal taxable income. So does this mean that noneconomic damages for things like emotional distress or loss of enjoyment of life are taxable? Not necessarily.
The IRS explains in a regulation. "Emotional distress is not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2)." (26 C.F.R § 1.104-1(c)(1) (2024).)
Attribution is the key. If you're hurt in a car accident, you'll probably suffer physical injuries—broken bones, brain damage, torn muscles or ligaments, cuts, bruises, and abrasions—to name only a few examples. When your emotional distress (or similar) injuries are attributable to your physical injuries or a physical sickness, the damages you collect for them likely can be excluded from your federal taxable income.
How to document attribution. How do you make sure that your depression, anxiety, fear, anger, and other emotional symptoms are attributed to your physical injuries? For starters, make sure your health care providers know that you're experiencing these problems because of your physical injuries and pain. The IRS will have a hard time disputing this kind of solid medical documentation.
Second, keep a journal or diary where you record your thoughts and recollections. When you experience emotional distress, be clear that it's because of the physical injuries you suffered in your accident. Keep your entries factual and to the point. A journal or diary won't have the same persuasive force as your medical records, but your writings are a valid source of proof.
Examples: Emotional Distress Damages Under § 104(a)(2)Jeff was a passenger in an automobile that was hit by another vehicle. Fortunately, Jeff didn't suffer any physical injuries. He did, however, experience emotional distress and anxiety for several months after the wreck. Jeff settled with the other driver's insurance company, which paid him $5,000 for his emotional distress damages. Because these damages can't be attributed to a physical injury, the entire $5,000 must be included in Jeff's federal taxable income.
Susan was the driver of the car in which Jeff's was a passenger. She suffered several broken bones, some requiring surgery to repair. After the accident, because her physical injuries were disabling, she was in pain, and her recovery was slow and difficult, Susan suffered severe depression, anger, and anxiety.
She settled with the other driver's insurer for $250,000. Of that amount, $50,000 was allocated to Susan's emotional distress, with the remaining $200,000 covering her past and future medical expenses. Because Susan's emotional distress was attributable to her physical injuries, Susan can exclude from her federal taxable income the entire $250,000 settlement.
No. As far as Uncle Sam is concerned, they're the same thing. In other words, the same IRS tax rules apply to both an out-of-court car accident settlement and to money you're awarded by a court after a car accident trial. The IRS isn't concerned with the source of the payment. It's interested in what the payment is meant to compensate you for.
If you enter into a written settlement agreement with the defendant (the party you're suing or bringing a claim against), you can negotiate over how much is being paid for your physical injuries. You can also make sure there's language in the agreement attributing damages for emotional distress and lost income to your physical injuries. The IRS isn't bound by your agreement, but as long as it was negotiated at arm's length and in good faith, it's likely to withstand scrutiny.
Alternatively, this language can be put into a release you sign if you don't have a formal written settlement agreement. Ask your lawyer for more information.
Did you receive a payment to cover repairs to your damaged car, or to reimburse you for your totaled vehicle? That vehicle damage payment probably isn't taxable. As long as the total payment doesn't exceed what the IRS calls your "adjusted basis" in your auto (generally, any cash you paid for it plus the amount of your car loan), the IRS won't tax it.
This rule also applies to payments you receive for loss of use of your car, like amounts to cover the cost of a rental vehicle while yours is in the shop.
If you were working at the time you were injured, your damages are likely to include some amount for lost income or loss of earning capacity. Are these amounts taxable? Once again, probably not.
As long as your lost income is attributable to a physical injury or physical sickness, those damages are excluded from your federal taxable income. In the unlikely event you suffer an income loss without any corresponding physical injury, any payment you get for that lost income will be taxable.
Examples: Treatment of Lost IncomeReturn to our examples above involving Jeff and Susan. Assume that, in addition to being paid $5,000 for emotional distress, Jeff also got $2,000 for lost wages. His entire $7,000 settlement must be included in his federal taxable income, because none of it can be attributed to a physical injury.
Assume further that Susan's $250,000 settlement included $50,000 for past and future lost income. The entire settlement still can be excluded from Susan's taxable income, since the lost income is attributable to her physical injuries.
Your car accident lawyer should be able to provide basic information on the taxability of your settlement or judgment. Keep in mind, though, that most personal injury lawyers aren't experts in tax law. So, if you've got more complex questions about the tax implications of your car accident settlement or judgment, or if you need to know whether your state follows the IRS tax rules, it's best to get tailored advice from a tax professional.