Black or White

• The tax law is black and white with regard to lost income damages and punitive damages. Both of these damages are taxable. Additionally, if the settlement award includes payment for interest on other types of damages, the interest is also taxable. These types of payments must all be reported as income on your IRS tax return.
  
  

Shades of Gray

• The tax issue becomes much more difficult when damages are paid for things other than lost income, or where the settlement agreement does not specifically identify the precise damages they have agreed to cover and the amount being paid on each. Settlement agreements are all a little different. Some identify the proportion of the payment that is attributable to each type of damage, but many do not. Agreements are often issued simply stating that one party will pay the other party a certain amount of money, but there is no breakdown of specific damage categories. When this happens, the person receiving the money should try to fairly estimate the amount that is attributable to lost income and punitive damages and include that amount as taxable income. Any amounts attributable to other damages, such as property damage or pain and suffering, are not taxable.
  
  

Taxpayer Beware

• One other "gotcha" may pop up relative to the settlement agreement from your auto accident. It often takes time for you to receive a settlement payment. This could cause some difficulty if the accident occurred in one tax year and you receive the payment in a later tax year. You may have claimed a tax deduction on medical expenses that you paid in the year that your accident occurred, and your settlement payment may include reimbursement for those same medical expenses. You will need to rectify this by paying additional income tax to balance out the tax deduction that you previously claimed on the same medical expenses. You cannot claim a deduction on medical expenses for which you are later reimbursed.
  
  

On Your Honor

• Like many other issues in U.S. tax law, payment of taxes on an auto accident settlement require self-compliance. Documents are not filed with the IRS that identify the amount of damages you receive or the amount of taxes due. In other words, it's generally up to you to be honest and make the best estimate on the amount of damages that should be included on your income tax return.