Auto Insurance Company Codes

Is an insurance settlement considered taxable income?

Wife was in an auto accident. Our attorney negotiated a small settlement with the insurance company. IRS claims we owe tax on the settlement because our attorney reported the settlement amount as nonemplyoyee compensation paid to us. I thought insurance settlements were nontaxabel income. Need help or the proper publication in the tax code to cite when I respond to the IRS. Thanks

Typically, an accident settlement resolves two types of claims: 1) damage to property and 2) personal injury. If any portion of your settlement paid for repairs to your car or reimbursed an auto insurance deductible, it is not considered income. It’s a “return of capital” that restores you to your position prior to the accident.

The personal injury portion of your settlement is likely not income as well. In general, damage awards are considered income by the IRS. However, Section 104(a)(2) of the federal tax code specifically excludes damages from personal injuries from taxable income. The only part that would be taxable any portion of your personal injury settlement that relates to punitive damages. Since your settlement is small, I’m guessing that isn’t an issue for you.

If your attorney reported the amount to the IRS as compensation to you, then he/she probably deducted the same amount on his/her own taxes as compensation expense. Consider whether you want to file a complaint with your state bar association. At the very least, your attorney should fix his/her own mistake for you at no additional cost.