Personal injury damages are generally not taxable. The notion is that when an injury victim sustains damages as a result of the tortuous conduct of another and subsequently obtains a recovery of personal injury damages that they are merely recouping a loss. The recovery of this loss does not result in any new income or increased benefit to the victim and they have simply been made whole or put back in the same position that they were in before the injury. Thus there is no taxable event. This is the general rule and as with all general rules there are exceptions.
Internal Revenue Code §104(a)(2) generally excludes from gross income all amounts recovered in connection with a personal injury claim. In order to qualify for this IRS exclusion the recovery must be the result of a physical injury and must have been caused by the tortuous conduct of another. In the situation where the tortuous conduct results in physical pain, mental anguish, physical impairment, disfigurement, medical expenses, loss of wage earning capacity, or other traditional elements of Texas personal injury damages then the recovery of those damages is not taxable.
The argument against taxing the recovery of “lost wages” under Texas law has been strengthened by recent legislative changes. Technically, Texas personal injury claimants have historically been limited to recovering “loss of wage earning capacity” rather than “lost wages” and the recovery of loss of wage earning capacity has not been included in taxable income under §104. This position was strengthened in 2003 when the Texas legislature enacted Civil Practice and Remedies Code §18.091. Section 18.091 provided that evidence of loss of earning capacity must be presented to the jury as a net loss after reduction for income tax payments. Thus the recovery of “loss of earning capacity” in Texas is “after tax” and it stands to reason that it would not be included in gross income for IRS purposes.
There are several notable exceptions to the §104 exclusions. Punitive damages are taxable. A claimant who recovers punitive damages is making a recovery over and above the claimant’s actual damages and thus the recovery of punitive damages amounts to new income to the claimant and they are appropriately taxable. However, it is important to note an exception to this exception exists in connection with gross negligence claims against employers who have worker’s compensation insurance and cause the death of an insured employee. Mental anguish damages which are not accompanied by a physical injury, such as in a case involving the intentional infliction of mental anguish, are taxable. Likewise, lost wages recovered in connection with a breach of an employment contract or an employment discrimination claim are taxable. There are additional less common exceptions.
While the general rule remains that personal injury recovery is not subject to federal income tax treatment the successful personal injury claimant would be well advised to consult with an income tax professional before spending their recovery.
For more information contact a Tyler Accident Lawyer today.