President Donald Trump’s new tax plan, The Tax Cuts and Jobs Act of 2017, signed into law on December 22, 2017, has changed how parties are taxed on personal injury payouts. Prior to this new tax plan, court-ordered payouts or negotiated settlements in car accidents, slip and falls, medical malpractice, and products liability cases were all considered tax-free compensatory damages. Damages awarded to punish defendants – punitive damages – were always taxable. Interest growth that a party earned from investing their payout and earning interest was also taxable. Finally, parties were able to deduct legal fees from their gross recovery and taxable income.
While punitive damages and interest growth are still taxable under President Trump’s new plan, there are significant changes regarding taxation of compensatory damages and the deduction of legal fees. For compensatory damages to qualify for tax-free treatment under the new tax plan, the recovering party’s injuries must be physical. Physical injuries include things like broken bones, paralysis, and other permanent physical disabilities. Under the new tax plan, compensatory damages for emotional distress or physical manifestations of emotional trauma are not tax-free. That means that if you were awarded damages because you suffered from depression, anxiety, post-traumatic stress disorder, or other symptoms of mental affliction, you will be taxed on the payout you receive.
If you have both physical and emotional symptoms, whether your payment will be tax-free depends on which symptoms caused or impacted other symptoms. For instance, if your physical symptoms – such as insomnia, headaches, or stomachaches – were triggered by your emotional distress, then your recovery would be taxable. If the reverse is true, and your physical symptoms caused your emotional distress, then your entire payment would be tax-free.
Another big change caused by the implementation of President Trump’s tax plan is that parties can no longer deduct legal fees from their total recovery and their gross income. Before the new tax plan, if your attorney received 30% of your settlement and you received 70%, then you would only have to pay taxes only on your 70% recovery. Now, if your attorney receives 30% of your settlement in legal fees and you receive 70% of the settlement, then you will have to pay taxes on 100% of the payout. There are only a few exceptions to this new policy. Your attorney’s fees can be excluded from your total income if you received compensatory damages for your purely physical injuries, there were no punitive damages awarded, and you are not earning interest on the payout. The same is true if the attorney’s fees were awarded by a court or required by statute.
It is still unclear how the new tax plan will actually affect payouts and settlements. Debates are certain to ensue over whether individuals suffered primarily physical or emotional injuries as to qualify for tax-free status. Parties may find that they need to reach out for additional tax help, so that they are prepared for any unexpected tax implications caused by the payout.