Money received from a car accident may or may not be subject to tax depending on the nature of the compensation. If the money received is merely a return on capital then it is not taxable. Return on capital is a fancy term referring to reinstating you to your original condition prior to the accident. For example, if you were in a car accident and your car was written off and you suffered injuries, the payment for the repair of the car and the medical bills for your treatment are not taxable. They were merely paid to return you to your original status; nothing was added to your value.However, if the money received is in the form of an income then it is taxable. This means that the money received was not just to return you to your prior status but also added value to you. An example would be punitive and compensatory damages. Both these awards are granted in addition to the actual damages incurred. Punitive damages are awarded to punish the wrongdoer and deter others from acting in a similarly reckless manner. On the other hand, compensatory damages include unearned wages because the victim was confined in the hospital and thus failed to report for work. This is essentially wages paid by the offender in return for the absences from work incurred by the victim. These two forms of compensation are taxable because they not only restored the victim to his original status but also added extra value or income to him.
The federal tax code enumerates the following non-taxable compensation for injuries or sickness:
- Amounts received under workmen’s compensation acts as compensation for personal injuries or sickness
- The amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness
- Amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness
- Amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country
- Amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action
In case the money received in connection to a car accident consists of taxable and non-taxable items, only the taxable portion will be taxed. For example, in a car accident settlement, the following awards are granted: repair of the car, hospital and medical bills, punitive damages, reimbursement for a month's worth of lost income, and costs of the settlement. Repair for the car and hospital and medical expenses are not taxable, while punitive damages and reimbursement for lost income are taxable. Sometimes, the settlement merely states a lump sum award without mention of the specifics. There must be a clarification in order to determine the tax implications of the settlement. It must indicate the purpose and breakdown of the award to avoid sustaining tax law violations.