Personal injury settlements in Missouri often require patience from accident victims. The insurance company of the at-fault party or parties may not be ready to pay full and fair compensation without extensive follow-up from a personal injury lawyer.
Once the settlement money hits the bank account, many recipients start wondering whether the money is taxable.
It is best to ask that question long before the settlement date as the answer may not be a simple “yes” or “no.” Like many situations in personal injury law and taxation, the answer is “it depends” and some planning may be required to avoid an unnecessarily high tax burden.
Your attorney will be able to explain what applies in your specific case, but the following are some general guidelines to bear in mind…
What are the main factors determining whether a settlement is taxable?
The majority of personal injury settlements awarded solely for personal injuries in Missouri are not subject to state or federal taxes.
However, it is essential to understand several exceptions and the factors that will determine whether any of these exceptions apply to your case—so that you do not have a nasty surprise at tax time.
Before assessing the taxability of your settlement, your personal injury attorney will consider the types of damages you receive and what their classifications are in your award. That is because diverse types of damages have different tax rules, just to complicate things.
Following are the general guidelines for different types of personal injury awards in Missouri…but bear in mind that laws can change and may be updated by the Internal Revenue Service (IRS) at any time.
Damages for physical injuries/sickness
The IRS states that settlements for personal injuries or sickness are not subject to federal income taxes.
For instance, a car accident victim who suffers physical injuries caused by another driver’s negligence can expect a settlement award for these injuries that incur no tax.
The main exception here is where an individual deducted medical expenses incurred because of the accident on a tax return for a previous year.
The victim, in this case, must include as income the portion of the settlement that reimburses him/her for those medical expenses. Medical expenses deducted over two or more tax years must be allocated on a pro-rata basis.
Damages for pain and suffering
Damages awarded in personal injury settlements for pain and suffering (sometimes called “emotional distress and mental anguish”) are also generally exempt from federal taxes according to IRS rules.
The main exception is if the pain and suffering were not caused by a physical injury or sickness. If it was caused by something else, that portion of the award is taxable.
Damages for lost earnings
Damages for lost wages and other income can be complex when it comes to taxes.
The taxability of awards for lost income should be checked at the state and federal level with a qualified source. Under some circumstances, compensation for the loss of income could be regarded as taxable income on tax returns. Failure to do so could cost you financial penalties.
Punitive damages
Punitive damages are rarely awarded in Missouri personal injury cases and the likelihood is that your case will not qualify for such damages. However, in cases where the at-fault party has behaved particularly egregiously, a judge may “punish” the defendant by awarding punitive damages to the plaintiff to discourage such behavior in society.
Importantly, any punitive damages awarded are taxable because they are not directly related to the injuries suffered—and should be declared as income on tax returns.
How can you minimize tax liability for personal injury settlements?
Nobody wants to pay more tax than necessary, but it is essential to remain within federal and state laws when it comes to taxation and personal injury settlements. The penalties for not doing so can be severe.
Following are some tips to remain on the right side of tax laws while minimizing your tax liability on personal injury settlements in Missouri.
Request a structured settlement annuity
A settlement annuity is where a sum of money is paid every year to the account holder. This can be a tax-effective way of receiving a settlement because it allows a considerable sum to be split into smaller annual payments, thereby potentially reducing the tax paid in any given year compared to a single lump sum payment.
This strategy requires a portion of the funds awarded to be used to purchase a structured settlement annuity.
The annuity provider should be a reliable insurance provider, responsible for paying the personal injury plaintiff a set amount according to a pre-agreed schedule—either annually for a few years or for the rest of his/her life according to future needs.
If the settlement includes taxable components, an annuity can help the plaintiff remain in a lower tax bracket and, therefore, pay lower taxes each year, while also providing a steady source of income for the future unaffected by market volatility.
Set up a qualified settlement fund
Another financial vehicle that may help plaintiffs in personal injury cases is Qualified Settlement Funds (QSF).
By setting up a QSF, the plaintiff can help defer tax payments on settlement proceeds by holding the proceeds in trust. This is especially useful for a plaintiff with a complex settlement arrangement or ongoing litigation to attend to,
Maximize the medical expense exclusion
Medical expenses are a major component of many personal injury settlements—which is beneficial because awards for these expenses are excluded from a tax liability.
Sometimes, it can be beneficial for a plaintiff to allocate settlement proceeds to tax-free medical expenses even when the settlement is not based on a physical injury.
For example, emotional anguish suffered due to workplace discrimination may legitimately be allocated future and past medical expenses to treat mental health symptoms like anxiety and depression, etc.
Allocate damages carefully from the settlement
Plaintiffs can legitimately work with their personal injury attorney or accountant to allocate parts of the personal injury settlement to different tax-free types of damages.
This could be the reimbursement of costs related to physical therapy, pain and suffering or other categories related to physical injuries or sickness resulting from their accident.
Discuss tax minimization with your personal injury lawyer
If your personal injury attorney does not raise the topic with you, ask how you may be able to minimize your tax liability with your eventual settlement. It is best to address this before the settlement is agreed so that the right tax planning steps can be executed.
If your lawyer cannot answer your questions, he/she should refer you to a qualified professional, such as a tax lawyer, who can help you minimize tax using proven tax-planning strategies.
For any questions about the tax implications of personal injury settlements and to optimize your claim in the Greater Kansas City area, please contact Noland Law Firm, LLC for a free case evaluation. Call us at (816) 781-5055 or contact us directly online.
