Income Received Under Unfortunate Circumstances Might Still be Taxable

By Kelly M. Walsh

The Internal Revenue Code broadly defines “gross income” for federal income tax purposes to mean “all income from whatever source derived.” It is not always that clear, though. The code goes on to name a list of items that specifically are income, as well as to carve out a number of items that specifically are not income for income tax purposes.

There are some instances in which having to pay income tax for money you receive under unfortunate circumstances, such as a serious injury or the death of a loved one, just adds insult to injury. In some of those cases, the Internal Revenue Code has specifically excluded those from gross income, but not always.

Workers’ Compensation:

Workers’ compensation benefits received under a workers’ compensation act or statute for a work-related injury or illness are fully exempt from income tax, and do not have to be reported in gross income.

Unemployment Compensation:

Unemployment compensation is specifically included in gross income for income tax purposes, so it is subject to income tax.

Social Security Disability:

Social Security income, including Social Security Disability, is reportable on income tax, but not all of it will be taxable. The amount that is included in your gross income for income tax purposes can be up to 85% of the Social Security benefits you receive over the course of the year. However, it is often less, and in many cases none of the Social Security income will be taxed. The percentage of Social Security that is included in the taxpayer’s taxable portion is calculated based on the taxpayer’s other income. More income overall means more of your Social Security will be taxable.

Wrongful Death and Other Legal Settlements:

When a taxpayer receives settlement proceeds, the taxability of those proceeds depends upon the character of the claims that are settled. As a general rule, proceeds from litigation settlements are gross income unless the taxpayer proves that the proceeds fall within a specific statutory exclusion. The exclusions available are based upon the type and character of the settlement proceeds.

When the settlement is resolving personal physical injuries or physical sickness, the income is not taxable so long as the taxpayer did not already take an itemized deduction for medical expenses related to the injury or sickness. If the taxpayer did already take an itemized deduction, the settlement proceeds are taxable income based on the extent to which the taxpayer already received that benefit in prior years.

When the settlement is for emotional distress or mental anguish, it is necessary to determine if the emotional distress or mental anguish is arising out of a physical injury or physical sickness. If it is entirely arising out of a physical injury or physical sickness, it is treated the same as a settlement of a physical injury or physical sickness. If it does not originate from a personal physical injury or physical sickness, the settlement is taxable income. That taxable income can be reduced by deducting amounts paid for medical expenses attributable to the emotional distress or mental anguish that were not deducted on previous returns.

When the settlement is for lost wages, the settlement is taxed as wages. It is subject not only to income tax, but also to Social Security and Medicare taxes. If the individual may apply for Social Security Disability, this may extend the individual’s insured status for SSDI benefits. It also contributes to the individual’s income base for drawing Social Security retirement benefits in old age. However, in terms of the immediate tax burden, this is the greatest possible burden.

When the settlement is for punitive damages, the punitive damages are taxable income, and not subject to reduction based on medical expenses.

Inheritance:

Money you receive as a payout from life insurance upon the death of a loved one, or an inheritance, are not subject to income tax for you, the surviving beneficiary. They may be taxable to your loved one’s estate, though. Additionally, if the life insurance earns interest before it is ultimately disbursed to you, then you will be required to pay income tax on the interest.

Survivor Benefits and Employee Death Benefits:

Survivor benefits are generally included in gross income and subject to income tax. Survivor benefits are specifically excluded from gross income only if they are attributable to service by a public safety officer who is killed in the line of duty. Even then, the IRS will treat the survivor benefit as gross income for income tax if the public safety officer’s death was caused by the decedent’s own misconduct, intoxication, negligence, or other actions that contributed to the death.

Employee death benefits are generally also included in gross income, except in limited circumstances. They are not included in gross income and therefore not taxed only if the employee was an astronaut who died in the line of duty or death benefits paid specifically because the employee died as a terrorist victim.

If you have received or are expecting moneys that are a change from your usual income, and you are unsure of the tax consequences, call Scaringi Law 717 657 7770 and talk to a tax attorney to determine what tax consequences you should plan for.