Wrongful death settlements compensate certain surviving family members for both financial and nonfinancial losses. Although there are exceptions to every rule, family members who receive a wrongful death settlement do not usually need to worry about paying taxes on the settlement proceeds.
Wrongful death compensation generally covers the financial and nonfinancial losses that spouses and children experience as the result of a loved one’s death caused by another person’s negligence. Other relatives may also be able to participate, including parents and stepchildren who depended on the deceased victim for financial support, children of any child of the victim who died before the victim, and siblings if the victim had no children.
Financial losses include the contributions that the deceased victim would have made to the family member if the family member had not died, including gifts and direct support (such as making mortgage payments on the home in which a spouse lives). Financial losses also include the value of lost services. Homemaking, home repairs, and financial planning are examples of services that that should be included in compensation if the deceased victim provided them to family members.
Nonfinancial losses include loss of the deceased’s love, companionship, comfort, care, assistance, protection, affection, society, and moral support. Spouses may also recover compensation for the loss of enjoyment of sexual relations with the deceased victim, and children can recover compensation for the loss of guidance and training that the deceased parent would have provided.
Income tax is generally paid on “earnings,” although “earnings” is broadly defined as any money received in exchange for effort, other than replacement of capital. Filing a lawsuit or making an insurance claim may be the kind of effort that generates earnings.
As a general rule, however, Congress has decided not to tax compensation that is paid for physical injuries or for emotional injuries that accompany a physical injury. While the relative who makes a wrongful death claim does not personally suffer a physical injury, the IRS has interpreted the law to include compensation for a relative’s death if the death is caused by a physical injury.
Compensation for emotional injuries that are not caused by physical injuries may be taxed. For example, emotional distress arising from employment discrimination may be taxable. In a wrongful death case, however, that distinction does not matter, because wrongful deaths are always caused by a physical injury.
The term “physical injury” includes “physical illness.” For example, if a relative was negligently exposed to a toxic chemical or to a cancer-causing substance, compensation for the relative’s wrongful death due to illness caused by that exposure would not be subject to taxation. The same is true if a relative unnecessarily died from a disease that a doctor negligently failed to diagnose.
The exemption from taxation extends to compensation for emotional injuries resulting from a wrongful death, including the loss of love and affection, the loss of sexual relations, and the loss of training or guidance. Compensation for these emotional injuries is not taxable because they resulted from a death that was caused by physical injuries. The IRS therefore treats the compensation as meeting the “personal injury” exemption from taxation.
Finally, the exemption from taxation extends to compensation for lost financial contributions, including gifts and services, that the relative would have provided if the relative had not died. Whether that compensation is viewed as replacement income (which might be subject to income tax) or replacement of gifts (which might be subject to gift tax, albeit rarely), the IRS has decided that any wrongful death compensation for the deceased relative’s financial contributions relates to physical injuries or illness and is therefore not subject to taxation.
The primary exception to the tax-exempt status of wrongful death compensation relates to punitive damages. Federal tax statutes allow awards of punitive damages to be taxed, even if they relate to a wrongful death.
Juries award punitive damages to punish malicious or reckless conduct. Ordinary negligence, such as falling asleep at the wheel and killing another driver in an intersection accident, will not usually permit an award of punitive damages. However, falling asleep at the wheel after taking illicit drugs might well be the kind of reckless behavior that will permit a jury to award punitive damages.
In a few states, only punitive damages can be awarded for a wrongful death. Oddly, in those states punitive damages in a wrongful death case are not taxed. In California, however, punitive damages and compensatory damages are awarded separately. Punitive damages awarded by a California jury are therefore subject to federal income tax.
Most wrongful death cases settle. A settlement has significant advantages from a taxation perspective. Settlement documents can be drafted to make clear that wrongful death compensation is being paid for compensatory damages, not for punitive damages. That language will usually shield a relative from paying taxes on wrongful death compensation.
A wrongful death lawyer is in the best position to negotiate a settlement that can be shielded from taxation. Relatives of a deceased accident victim who believe they may have a wrongful death claim can learn more about their rights by consulting with a California wrongful death attorney.
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