Are Workers' Compensation Benefits Taxable?

Workers’ compensation claims are a common concern for many employees suffering work-related injuries. This system provides payments for lost wages and medical expenses, often paid through a workers’ compensation settlement. Are these benefits taxable?

In general, workers’ compensation benefits are not taxable at the state or federal level. This often means you won’t have to include these benefits when you file a tax return. There are some important exceptions, particularly if you also receive Social Security benefits.

This article provides a brief overview of workers’ compensation insurance and taxes. With the help of a workers’ compensation attorney, you may be able to obtain a workers’ compensation settlement and avoid any unpleasant tax surprises.

Workers’ Comp Is (Usually) Tax-Free

For federal income tax purposes, compensation awarded under a workers’ compensation act for a work-related sickness or injury is fully exempt from taxes. This applies regardless of the benefit type, including disability payments, lump-sum settlements, and death benefits paid to survivors.

Workers’ compensation is in the same category of non-taxable income as:

• Payments from public welfare funds
• Compensatory (but not punitive) damages for physical injury or sickness
• Disability benefits under a “no-fault” car insurance policy for loss of income or earning capacity
• Compensation for permanent loss or loss of use of a part of your body

In most cases, workers’ comp claims remain nontaxable. However, there are exceptions.

The Major Exception: The Social Security (SSDI) Offset

Part of your combined benefits (workers’ comp benefits and SSDI payments) may be taxable. This portion is called the “Social Security offset.” The Social Security Administration (SSA) rules don’t allow your total combined benefits to exceed what you would have made while you were working. Once that happens, your benefits stop being “compensation” and become “income” again.

To avoid that situation, the law caps your combined benefits at 80% of your average monthly earnings before you stopped working (the “80% rule”). Any amount over that is deducted, or “offset,” to keep your total compensation below 80% and tax-exempt.

Let’s use an example to show how that works. Suppose your pre-injury average monthly pay was $4000/month. This means that:

• Your 80% limit for total benefits is $3,200/month. Any amount over that becomes taxable income.
• If you receive SSDI benefits of $2,000/month and a workers’ comp benefit of $1500/month, your combined total is $3,500/month. This would be $300/month over the 80% limit.
• The SSA will offset your disability payments by $300. You’d receive $1,700 from SSDI and $1,500 from workers’ comp, keeping you at your legal limit.

The IRS may consider the “offset” part of your taxable Social Security income. Under federal law, the offset is considered part of your taxable SSDI payments, even though you never received it. In a distinction without a difference, your workers’ comp benefits aren’t being taxed, but your SSDI benefits are.

Only the offset amount should be taxed. If you’re in a situation like this and uncertain about whether you should be getting taxed, consider speaking with a workers’ compensation attorney.

Lump Sum Payments

In some cases, you may accept a lump sum payment rather than payments for medical bills and lost wages. This is often the case for work-related illness diagnosed after the worker has left employment, such as a black lung diagnosis and treatment. A lump sum payment can include wage replacement and other lost income, medical costs, and non-economic damages like emotional distress.

A lump sum payment for back pay and medical expenses is usually not taxable, but some parts of it may be. These can include:

• Interest for delayed payment
• Money specifically allocated for non-economic damages such as emotional distress could be taxable

Any settlement agreement should consider these possibilities. An attorney can explain structured settlement agreements and the tax implications of these payments.

Practical Steps for Injured Workers

Finding out the hard way that you owe taxes on a workers’ comp payment can be an unpleasant and unwelcome surprise. Stay up to date on all requests and retain all documents related to your case. In addition, keep these factors in mind:

• Review Your Award Letters: When you get award letters, read them carefully. If you see any terms like “offset,” “reduction,” or mention of 80% of your earnings, your benefits may be taxable.
• Don’t Ignore IRS Form SSA-1099: At the end of the year, you’ll get a Form SSA-1099. Check if the amount in Box 3 is higher than the SSDI payments you received. This may be due to the workers’ comp offset, and must be addressed in your tax return.

If you’re not sure about paying your taxes, get help. A tax attorney or CPA is less expensive than making a mistake filing your tax returns.

Get Legal Help With Your Benefits

Workers’ compensation cases can be complex. Each individual’s tax situation is unique. Anything involving taxes can get complicated quickly, especially if your injuries are severe. A skilled workers’ compensation lawyer can provide valuable legal advice and help you understand your rights.

FindLaw’s directories of tax attorneys and workers’ comp attorneys can get you started. Select your state or city to review contact and ratings information for local legal professionals. Many law offices offer free consultations.