Personal injury settlements and judgments may have federal and state tax implications if the settlement or judgment is considered "Gross Income" so it is important to keep this in mind when bringing legal claims.

Connecticut defines Gross income as all income you received in the form of money, goods, property, services not exempt from federal income tax.

The Internal Revenue's general rule regarding taxability of amounts received from settlement of lawsuits and other legal remedies is Internal Revenue Code (IRC) Section 61. This section states all income is taxable from whatever source derived, unless exempted by another section of the code.

Internal Revenue Code (IRC) Section 104 provides an exclusion from taxable income with respect to lawsuits, settlements and awards. However, the facts and circumstances surrounding each settlement payment must be considered to determine the purpose for which the money was received because not all amounts received from a settlement are exempt from taxes. The key question to ask is: "What was the settlement (and its corresponding payments) intended to replace?"

IRC SECTION AND TREASURY REGULATION

IRC Section 61 explains that all amounts from any source are included in gross income unless a specific exception exists. For damages, the two most common exceptions are amounts paid for certain discrimination claims and amounts paid on account of physical injury.

IRC Section 104 explains that gross income does not include damages received on account of personal physical injuries and physical injuries.

IRC Section 104(a)(2) permits a taxpayer to exclude from gross income "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 injuries or physical sickness

Reg. Section 1.104-1(c) defines damages received on account of personal physical injuries or physical sickness to mean an amount received (other than workers' compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.

So, to summarize, the general rule specific to personal injury claims is that the proceeds for compensatory damages are not taxable under federal or state law. This rule applies whether the claim was settled prior to or after filing a lawsuit, or whether the proceeds were awarded in a verdict following a trial. 

The reason for the general rule is that compensation for compensatory damages is meant to essentially reimburse an individual for the losses suffered as a result of an injury. As such, any compensated gain is meant to offset the losses, so there is no net gain from the proceeds.

So, the takeaway here is to ensure that your personal injury attorney properly structures your claims and the terms of any settlement to minimize or even eliminate any tax consequence.