Are Personal Injury Settlements Taxable in New York?
Demystify the tax implications of personal injury settlements in New York. Get essential insights into how your compensation is treated by tax laws.
A personal injury settlement represents financial compensation received by an individual who has suffered harm due to another party’s negligence or wrongful actions. These settlements are reached outside of court through negotiations. The tax treatment of these settlements varies significantly based on the specific components of the compensation received.
Federal Taxability of Personal Injury Settlements
The Internal Revenue Service (IRS) generally excludes from gross income any damages received on account of personal physical injuries or physical sickness, as outlined in Internal Revenue Code (IRC) Section 104. This rule aims to ensure that individuals are made financially “whole” after an injury, rather than treating the compensation as taxable income. This exclusion applies to both lump-sum payments and periodic payments from structured settlements.
Compensation for medical expenses directly related to the physical injury or sickness is typically not taxable. This includes costs such as doctor visits, hospital stays, surgeries, medications, and rehabilitation.
Damages for pain and suffering are also generally excluded from taxable income if they arise from personal physical injuries or physical sickness. This encompasses both physical pain and emotional distress directly resulting from the physical injury.
Lost wages are another component that can be excluded from taxable income if they are directly attributable to a personal physical injury or physical sickness. This means compensation for income an individual would have earned but could not due to their physical injury or illness is generally tax-free. The underlying reason for the payment, which is the physical injury itself, makes these compensatory damages non-taxable.
However, certain types of damages within a personal injury settlement are always taxable. Punitive damages, which are awarded to punish the defendant for egregious behavior rather than to compensate the injured party, are fully taxable as ordinary income.
Emotional distress damages that do not stem from a personal physical injury or sickness are generally taxable. For instance, compensation for emotional distress resulting from defamation without any physical harm would be considered taxable income. The key distinction lies in whether the emotional distress is a direct consequence of a physical injury.
Any interest earned on a personal injury settlement is also taxable. This applies to interest that accrues from the time of the injury until the settlement is received, or interest earned on settlement funds held in an interest-bearing account.
New York State Tax Treatment
New York State generally aligns its income tax treatment of personal injury settlements with federal tax laws. This means that if a component of a personal injury settlement is excluded from gross income for federal income tax purposes, it is typically also excluded from New York State income tax. Therefore, damages received for personal physical injuries or physical sickness, including compensation for medical expenses, pain and suffering directly related to physical injury, and lost wages due to physical injury, are generally not subject to New York State income tax. Similarly, if a portion of the settlement is taxable under federal law, such as punitive damages or interest income, it will typically also be taxable at the state level. New York does not impose unique or significant deviations from the federal rules regarding the taxability of these settlements.
Handling Legal Fees and Other Expenses
The tax treatment of legal fees incurred in obtaining a personal injury settlement has been significantly impacted by legislative changes. Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, some legal fees could be deducted as miscellaneous itemized deductions, subject to a 2% adjusted gross income (AGI) limitation. However, the TCJA suspended miscellaneous itemized deductions for individual taxpayers through 2025.
As a result, for most individual taxpayers, legal fees related to personal physical injury or sickness settlements are generally not deductible from gross income. This means that even if a settlement is largely tax-free, the plaintiff cannot typically deduct the attorney’s fees paid from the gross settlement amount.
However, if a portion of the settlement is taxable, such as punitive damages, there can be complex rules regarding the deductibility of legal fees attributable to that taxable portion. In some limited circumstances, legal fees related to certain types of taxable awards, like those for unlawful discrimination or whistleblower awards, may be deductible “above the line,” meaning they reduce gross income directly. This exception is less common for typical personal physical injury cases.
Tax Implications of Structured Settlements
A structured settlement involves receiving compensation for a personal injury claim through a series of periodic payments over an agreed-upon period, rather than a single lump sum. This arrangement is often funded by an annuity purchased by the defendant’s insurance company. For personal physical injury or physical sickness cases, structured settlements offer distinct tax advantages.
If the underlying personal injury settlement is tax-free under federal law (i.e., for physical injuries or sickness), then the entire stream of payments from a structured settlement typically remains tax-free. This includes not only the principal amount of the settlement but also any interest or growth earned on the annuity that funds these payments. This tax-free growth is a significant benefit, as investment gains on a lump-sum settlement would generally be taxable if invested privately.
The tax-exempt status of structured settlement payments for physical injuries is codified under IRC Section 104(a)(2) and further supported by the Periodic Payment Settlement Tax Act of 1982. This ensures that the recipient receives their compensation and its growth without incurring federal, state, or local income tax liability on the payments. This structure provides long-term financial security and predictability, without the burden of managing investments or paying taxes on the earnings.