Attorneys work hard to ensure that their personal injury settlement agreements are airtight from a legal perspective. However, attorneys sometimes neglect to include a specific federal income tax allocation provision, which can often have wide-ranging consequences for all parties involved.

A carefully drafted tax allocation provision can provide guidance for all parties to the settlement agreement on how to treat personal injury proceeds for federal income tax purposes, including (i) whether the recipient parties should include all or a portion of the settlement proceeds as gross income, (ii) whether the paying parties should issue a 1099 to the recipient and (iii) what portion of such proceeds, if any, will be deductible. Generally, the IRS will not disturb an allocation agreed to by the parties of a settlement agreement if it is generally consistent with the substance of the settled claims.

The IRS has issued guidelines regarding the taxation of personal injury proceeds. Any amounts received as a result of a personal injury or wrongful death settlement can be taxable, nontaxable, or partially taxable depending on the type of case and the type of compensation for injuries suffered. Proceeds received as a result of physical injuries or sickness, e.g., compensation for medical bills, are excludable from gross income under IRC § 104(a)(2). Proceeds that are not a result of physical injuries or sickness are taxable. For example, payments for lost wages (or if you are a business owner, lost business income) are generally taxable and are also often subject to Social Security and Medicare taxes.

Proceeds received as a result of emotional distress or mental anguish are only tax-free if the emotional distress or mental anguish is a direct result of a physical injury or illness. Proceeds received for emotional distress or mental anguish that do not originate from a personal physical injury or physical sickness must be included in income. However, the amount you must include is reduced by: (1) amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted and (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit. Attorney’s fees associated with a monetary award for physical injuries and physical sickness may be nontaxable as well.

Other taxable personal injury settlements with nonphysical injuries include invasion of privacy, discrimination, harassment, and wrongful termination, which are taxed as ordinary income. Again, because there are no physical injuries, the settlement award is taxable. Further, punitive damages, which are relatively rare in the case of personal injury claims, are not excludable under IRC § 104(a)(2) and will thus be taxed as ordinary income.

Failing to address important income tax considerations in a settlement agreement may result in an IRS audit of one or more parties to the agreement. Further, if you are a recipient of personal injury proceeds and fail to include certain taxable personal injury proceeds as income on your 1040, the IRS will demand that you file an amended return with the correct amount owed, in addition to a substantial tax understatement penalty and interest on the amount owed. These issues are easily avoidable with the inclusion in a settlement agreement of a well drafted income tax allocation provision.