As a general rule, personal injury compensation is non-taxable income and no capital gains tax is charged on it. Put simply, this means you’ll get to keep all the money you’re given, apart from a small percentage which will be used to cover your solicitor’s fees.
The following elements of compensation are all tax free:
Tax laws are complex, and whether you’ll have to pay income tax on general damages depends on what the payment covers. For example, if you’re awarded damages to compensate for lost earnings – the compensation claimed will usually be net of income tax. The aim is that you’ll be placed in the same financial position as if the accident never took place, ie. you would have received your usual pay net of income tax. This means that you will not have to pay income tax on those damages if they’re the same as your net pay.
But what if you’re self-employed and are claiming compensation to cover loss of income because you’ve missed out on a freelance job? In this case, you would probably receive general damages gross, in which case HMRC would treat it as taxable income and you’ll have to declare it on your tax return.
Interest will usually build up on your compensation from when your injury happened until the date your case is settled. The tax will already have been paid on that interest by the defendant, so you won’t have to.
Once your claim is completed, you’ll usually receive your compensation quickly. But if, for whatever reason, there’s a delay in the compensation being paid to you after your case is finished, then any interest would need to be declared as income because you’ll probably receive the compensation gross (ie. including the interest). This will be taxable income and must be declared to HMRC in your personal tax return.
However, if there’s a delay in payment of the compensation under an out-of-court settlement, under the current rules you won’t have to pay income tax on any interest.
You might decide you want to invest your compensation, particularly if you’ve received a large amount. For example, you might place it in a separate building society account to keep it safe and earn some interest.
Any interest you receive after you’ve invested your compensation will be treated as taxable income (unless invested in a tax-free ISA, etc).
A personal injury trust is a trust set up with injury compensation, and the trustees will use the money for the benefit of the injured person (known as the ‘beneficiary’). This is a way of ringfencing money from being taken into account when means tested benefits is calculated.
Most personal injury trusts are ‘bare’ trusts, which means the injured person has full control (and is usually a trustee) and it’s intended only for them.
Income tax is payable on the trust income, such as interest on investments, as it’s treated as the beneficiary’s own income. But any capital paid out of the trust fund will not attract capital gains tax.
There are other types of personal injury trusts, such as discretionary trusts, but the tax treatment is more complex, especially if the beneficiary is disabled or vulnerable as they may then get preferential tax treatment. It’s very important to take into consideration the tax implications of creating a personal injury trust to avoid unexpected costs. This is something your solicitor may be able to advise you on.
Nicola is a dual qualified journalist and non-practising solicitor. She is a legal journalist, editor and author with more than 20 years' experience writing about the law.
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