I recently had a conversation with some colleagues about whether lost wages that are collected in a personal injury case are taxable as income. The answer is that they are not taxable and are excluded from a person’s gross income. The IRS excludes from gross income all funds received as compensatory damages when a person has suffered a personal injury or sickness. The IRS has had a long-standing policy that such damages should not be taxed.
Compensatory damages include all damages for medical expenses, pain and suffering, and lost wages. It is important to note that the compensatory damages must be received as a result of personal injury or sickness. However, the personal injury need not be suffered by the person collecting the damages, if the damages are related. This applies when a person asserts a claim for loss of consortium. A claim for loss of consortium is a claim that the spouse of an injured person has if the non-injured spouse society, affection and companionship of the injured spouse.
The main issue in the conversation with my colleagues was whether damages received for lost wages were taxable. As stated above, they are not. I agree that lost wages should not be taxable in this context for several reasons. First, when a person settles a personal injury claim, as opposed to going to court for a trial, the settlement rarely, if ever, outlines what each dollar of the settlement is for. Second, if the case went before a jury, there would need to be expert testimony about how the lost wages would be taxed. This would require calling unnecessary witnesses and spending unnecessary court time. Third, it would require too much supervision by the IRS of settlements and lawsuits across the country.
The compensatory damages excluded from taxable income cannot be related to damages received for claims other than personal injury or sickness, such as a claim for breach of contract. Also, punitive damages are not compensatory damages and are not excluded from gross income by the IRS.