If you’ve received a personal injury settlement—or expect to—one of the most important financial questions you may have is whether that money will be taxed. After all the stress and disruption of an injury, the last thing anyone wants is a surprise tax bill from the IRS or the North Carolina Department of Revenue.
The good news is that most personal injury settlements are not taxable in North Carolina. But that doesn’t mean all parts of your compensation are automatically tax-free. There are some key exceptions that both federal and state tax authorities may treat differently depending on how your settlement is structured.
In this article, our personal injury lawyers in North Carolina will walk through the federal IRS guidelines, North Carolina’s tax rules, and the types of compensation that may or may not be taxed. Knowing this information ahead of time can help you plan better, avoid future tax issues, and make sure you keep as much of your settlement as possible.
When Personal Injury Settlements Are Tax-Free
Under Internal Revenue Code § 104(a)(2), the portion of a personal injury settlement received for physical injuries or physical illness is generally excluded from gross income. North Carolina follows the same rule and does not tax these portions of a settlement under state law.
This means that compensation for the following categories of a North Carolina personal injury settlement are not taxable:
- Medical expenses related to your injury
- Pain and suffering directly tied to a physical injury or illness
- Lost wages caused by an inability to work due to your injury
- Loss of consortium or enjoyment of life stemming from a physical injury
Whether your settlement comes from out-of-court negotiations or a judgment following trial, the key determining factor is whether your claim is tied to actual physical harm. If it is, then most of your compensation will likely fall under the tax-exempt umbrella at both the federal and state levels.
When a Settlement Can Be Taxable
Although much of a personal injury settlement is not taxed, there are important exceptions that could result in a portion of your compensation being treated as taxable income.
These exceptions are based on the nature of the claim, how the damages are categorized, and whether the compensation relates to something other than a physical injury.
Here are the most common taxable components:
1. Emotional Distress or Mental Anguish Not Linked to Physical Injury
If part of your settlement compensates you for emotional distress or mental anguish, and that distress did not result from a physical injury, it is considered taxable. For example, if you sued your employer for harassment and received compensation for emotional harm—but not for a physical injury—those funds are taxed just like regular income.
On the other hand, if emotional distress arose because of a physical injury—such as anxiety following a traumatic car accident—then that compensation would remain tax-exempt.
2. Punitive Damages
Punitive damages are always taxable under federal law, regardless of whether the underlying case involved a physical injury. These types of damages are awarded not to compensate you for a specific loss, but to punish the defendant for gross negligence or intentional wrongdoing.
North Carolina allows for punitive damages in limited cases, such as those involving fraud, malice, or willful and wanton conduct. If your case results in a punitive damage award, you should plan on paying income tax on that portion.
3. Interest on the Settlement
If your settlement includes interest on the award—for example, interest that accrues between the time of judgment and the time payment is made—that interest is treated as taxable income. This is true at both the federal and state levels.
4. Reimbursement for Previously Deducted Medical Expenses
If you took a deduction for medical expenses on a previous year’s tax return and later received a settlement that reimburses you for those same expenses, you may have to repay that deduction.
This is known as the tax benefit rule. The IRS will not allow you to benefit twice—first by reducing your taxable income with a deduction and again by receiving tax-free reimbursement for those same expenses.
Your attorney or tax advisor can help determine whether this applies based on your prior tax filings.
Lost Wages: Taxable or Not?
This is a common area of confusion. Generally speaking, lost wages related to a physical injury are treated the same as other injury-related compensation and are not taxable. That’s because they’re part of your recovery from physical harm.
However, if you are awarded lost wages in a claim that does not involve a physical injury—such as a wrongful termination or breach of contract claim—those amounts would be subject to federal and state income taxes, just like a regular paycheck.
In some cases, settlements may contain a mix of injury-related lost wages (non-taxable) and unrelated lost income (taxable), so it’s essential to understand how the claim is categorized in the final agreement.
How the Settlement Is Structured Matters
The way your settlement agreement is worded and allocated can affect how the IRS and North Carolina tax authorities treat your compensation. For example, if the agreement clearly states that the payment is for medical bills and pain and suffering due to a physical injury, that language supports the non-taxable status of those funds.
If the agreement is vague or leaves room for interpretation, the IRS may scrutinize the details more closely—and potentially consider portions of the settlement as taxable income.
This is why it’s so important to work with an attorney who understands both personal injury law and the tax implications of different settlement structures. It’s also wise to consult a qualified tax professional before filing your return in the year you receive the settlement, especially if your compensation includes any of the exceptions discussed above.
State Tax Laws in North Carolina
North Carolina does not tax personal injury settlements separately from federal guidelines. In most cases, if your settlement is not taxed by the IRS, it won’t be taxed by the state either. The North Carolina Department of Revenue generally conforms to federal income tax rules in personal injury cases.
However, if a portion of your settlement is taxable at the federal level—such as punitive damages or emotional distress unrelated to a physical injury—it may also be subject to state income tax. Be sure to review both state and federal guidelines or speak with a tax professional to avoid surprises when you file your return.
What You Should Do if You’re Expecting a Settlement
If you’re in the process of resolving a personal injury claim or have recently received a settlement, the best way to protect yourself is to understand what type of compensation you’re receiving and whether any portion of it might be taxed.
Review your settlement agreement carefully, and don’t hesitate to ask your attorney for clarification. In some cases, it may be necessary to work with a CPA or tax advisor to ensure your tax return is accurate and that you don’t inadvertently report (or fail to report) income improperly.
Keep copies of your settlement agreement, 1099 forms (if any), medical records, and past tax filings. This documentation can be important if the IRS or the North Carolina Department of Revenue ever questions your return.
Have Questions About the Taxability of Your Settlement?
In most personal injury cases involving physical harm, your settlement will not be taxable. But depending on how the settlement is structured and what types of damages are included, some portions may be subject to federal or state taxes.
Understanding what’s taxable—and what’s not—can save you from future tax problems and help you make the most of your recovery.
If you have questions about your personal injury settlement or need help navigating the legal or financial aspects of your case, we’re here to help.
At Auger & Auger, we have over 30 years of experience helping injury victims recover full and fair compensation—and understand what to expect every step of the way.
Schedule your free, no-obligation consultation today. Let us help you move forward with clarity, confidence, and peace of mind.
