If you have been injured in an accident and are set to receive a personal injury settlement or disability benefits, one of the important questions that always comes to mind is how the benefits will be taxed. Understanding how such payments impact an individual’s tax liability is critical to determining whether a settlement and/or disability benefits can truly place someone in the position they would have been but for the injury. Personal injury damages and disability benefits are unique areas of Canadian law from a tax perspective, compared with other types of damages and income.
In addition to those individuals who have already suffered an injury or disabling condition, it is important for uninjured persons to understand their disability insurance options and how income taxes might impact which option to choose in the unfortunate event that disability benefits need to be drawn on at some point.
Many workers have disability benefits provided through their workplaces. There are also other options to purchase disability coverage on an individual basis. While this blog is not intended to be an exhaustive discussion of these topics, it is designed to provide helpful background for individuals facing such decisions.
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Taxation of Personal Injury Settlements and Awards
Generally speaking, awards of damages for personal injury, whether awarded by a court or received through a settlement agreement are not taxed under Canadian law. This is generally provided for in the regulations set forth by the Canadian Revenue Agency (CRA) and can be found at IT-365R2.
Included in the types of damages that can be excluded from income in this category would be medical and hospital expenses, loss of future earnings, and general damages for items such as pain and suffering, loss of amenities of life, loss of earning capacity, shortened expectation of life and similar items. For injured parties, this can make a significant difference to the overall value of personal injury settlements because there is no income tax payable.
Taxation of structured settlements and annuities
Another attractive option from a tax perspective for individuals receiving a personal injury settlement is to consider a structured settlement or annuity. This option involves receiving payments over a specified period of time, instead of receiving a lump sum at the time of the settlement. All of the payments received in a structured settlement, including interest, are tax free. However, certain strict criteria need to be met in order for a structured settlement to gain this favorable tax treatment. Those criteria are the following:
-The award must be made in respect to personal injury or death;
-The plaintiff and the insurer must agree on whether the monies paid will be paid on a period, fixed or life term.
-The insurer must purchase the annuity contract and it must be non transferable and non-assignable;
-The insurer must remain liable to make payouts according to the agreed settlement
Although structured settlements do provide another good tax free vehicle for recipients of personal injury settlements, they are somewhat inflexible once that option is elected and as such, they need to be carefully considered before determining whether that is the best route in a particular case.
One notable exception to the general rule that personal injury damages are not taxable under Canadian law is damages that are reasonably considered to be income from employment rather than an award of damages. Therefore, there are some instances where damages received as part of a personal injury settlement might be taxable if that portion of the damages is attributable directly to income from employment rather than damages for personal injury.
Taxation of Disability Benefits:
Whether or not disability benefits are subject to income tax in Canada depends on several factors which are discussed below. The tax treatment of disability benefits depends on what type of disability policy your benefits are paid through. Disability insurance is primarily used as a vehicle to protect you and your family from financial ruin in the event that you are unexpectedly able to work due to either an injury or illness. There are different types of benefits depending on whether an injury is temporary or long term and also whether it is work related or not.
Disability insurance benefits will generally pay between sixty (60) percent and eighty-five (85) percent of a person’s regular income up to a maximum benefit amount and sometimes on a time limited basis depending on the type of benefits. Generally speaking, if the employee has paid for the entire amount of the disability premium, the disability benefits will be paid to the employee tax free in the event that the employee needs to draw upon them. This can certainly make a large difference in how far the benefits go toward meeting an employee’s obligations if there is income tax impact to the employee.
In the instance where an employer pays part of the entire amount of the disability premiums, the disability benefits are then subject to income tax. Thus, an employer’s benefit plan may end up not being sufficient income for an employee after considering the income tax impact of the payments. This is also another reason that many employees purchase their own supplemental disability coverage to ensure that their income needs are met in the unfortunate event of a disability or injury.
If employees do elect to purchase supplemental coverage in addition to an employer provided plan, there is typically an offset of the benefits received from one plan versus another plan. In addition to private disability plans, employees who have paid into the Canada Pension Plan (CPP) may also be able to receive a disability benefit if they have contributed to those plans and are not able to work regularly because of a disability.
Have questions? Contact an experienced personal injury and disability benefits lawyer
Whether you are the potential recipient of a personal injury settlement or the recipient of disability benefits, proper consideration of the tax impact of such payments is very important in determining the overall impact of the settlement and/or payments on a person’s livelihood and future. If you’re having trouble, get in touch with one of our experienced lawyers for help.