When someone is physically injured on the job, shouldn’t the IRS consider the entire settlement proceeds as non-taxable income? The answer is complicated.
Tax attorney Robert Wood explains how timing and semantics play a role in the tax status of physical (and emotional) damage settlement proceeds in his piece “Emotional Distress Damages Are Taxable, Physical Sickness Damages Are Not, How Come?” Robert says that if a worker’s emotional distress causes physical sickness or injury, all damages are taxable but if a physical sickness or injury causes emotional distress, the emotional distress damages are excludable from income. “The order of events and how you describe them matters to the IRS,” Robert says.
This is important when crafting a structured settlement for your client. Qualified structured settlements (personal physical injuries) fall under 26 U.S. Code §104. All proceeds accumulate in the structured settlement annuity tax-free. When the money is withdrawn, no taxes are owed on the withdrawn amount.
Non-qualified structures (including those for emotional distress and any physical injures as a result of emotional distress) accumulate tax-free within the annuity, but proceeds are taxable once withdrawn.
Robert goes on to say, “Whenever possible, settlement agreements should be specific about taxes. The IRS is likely to view everything as income unless you can prove otherwise…Medical records and settlement agreement language can help materially.”
I highly recommend reading Robert’s piece.
If you have any questions, feel free to call anytime with questions.