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Workers' Comp and Taxes

Kimberlee Leonard
Kimberlee Leonard

There are certain tax implications for workers' compensation that every employee and business owner should understand.

When you receive workers' compensation benefits, in most cases, you will not have to pay state or federal taxes on the money you receive. It is important to realize that every state is different and there may be instances where you will have to include the income on your tax return. It's always best to consult a tax advisor when you will be receiving workers' compensation benefits.

Importance of workers' comp insurance

As far as business insurance goes, workers' compensation insurance is important for both an employer and its employees to have. While each gets a different benefit from the coverage being in place, it makes for a better employer-employee relationship and working environment.

Importance of workers' comp insurance for employers

Workers' compensation is an important insurance policy for employers to have. Not only is it required in most states, but it also helps employers prevent costly lawsuits for injuries that occurred on the job. The workers' comp policy pays medical benefits and lost wages to an employee who is injured while working.

While there are variations to state laws about who must obtain workers' compensation and what constitutes a valid compensation claim, most states require employers with at least one employee to obtain insurance that will pay if an employee is hurt at work.

Workers' comp is no-fault insurance, meaning there doesn't have to be negligence in order for a claim to be a valid. In exchange for the no-fault designation, an employee is not able to sue an employer that has a valid workers' comp policy – at least in most states.

Most importantly, an employer is not liable for the medical expenses and lost wages of an injured employee, which can be tens of thousands, or even hundreds of thousands, of dollars. Most employers don't have the resources to cover those costs without insurance.

Bottom LineBottom line: Workers' compensation protects both employers and employees, ensuring that anyone injured on the job is compensated and that the employer isn't forced to pay costs out of pocket.

Importance of workers' comp insurance for employees

The first workers' compensation law was passed in 1911 by Wisconsin, with all states following suit by 1948. The passage of laws coincided with an effort to help reform dangerous workplace environments so that workers would be safer and better protected. While not all accidents could be prevented, and some occupations posed higher risks than others, workers' compensation insurance helped give workers the confidence that they would be taken care of if an accident did happen.

For employees, the value of a workers' compensation policy is the assurance that there will be funding for medical expenses and lost wages if they are injured while working. Many employees who are injured incur thousands of dollars of medical expenses and may be away from the job for an extended period of time while recuperating. The workers' compensation policy pays those benefits during a claim.

Is workers' compensation tax deductible?

For employers, the premiums they pay for workers' compensation insurance are considered tax-deductible expenses. When insurance is deemed ordinary and necessary, a business owner can deduct the cost of insurance.

According to the IRS, "[a]n ordinary expense is one that is common and accepted in your trade or business." A workers' compensation insurance policy is a normal business expense, and because workers' compensation insurance is required by law, it is a deductible expense. It therefore meets both requirements to be tax deductible.

TipPro tip: The cost of workers' compensation insurance is tax deductible, and employers that have a policy will not be responsible for an injured employee's medical expenses or lost wages.

Are workers' comp benefits taxable for employees?

When employees are unable to return to work due to work-related injuries, they will receive both medical benefits and lost wages. While medical benefit are paid directly to the medical provider(s) that rendered treatment and are not taxable, lost wages may be taxable under certain circumstances.

In most cases, lost wages are not taxable. This is true as long as the employee is not receiving federal Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI) in addition to the lost wages. If they are, those benefits are taxable.

Workers' comp taxes: SSDI and SSI

SSDI and SSI are types of federal disability programs offered through the Social Security Administration (SSA). While they both offer cash benefits, they are distinguished by their eligibility requirements. Since neither one covers temporary disabilities, most injured workers will not qualify for either program.

To be eligible for SSDI, you must have an approved disability and have earned enough work credits over the course of your career. There is a five-month waiting period for SSDI, and you become eligible for Medicare after two years.

SSI is disability- and income-driven. As of January 2021, you can earn a maximum of $7,770 per year and still be eligible for SSI. There is a one-month waiting period after SSI approval before payments can begin.

The SSA has defined "disability" as "the inability to do any substantial gainful activity by reason of any medically determinable or physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months."

Thus, to be eligible for either SSDI or SSI, the worker must have sustained an injury that will prevent them from being able to work at their job or any other job for at least a 12-month period.

If you are injured and end up qualifying for SSDI or SSI, you will need to include your workers' comp payments on your tax return, as any payments you receive from either of these programs are subject to federal taxes. State laws do vary, so it is best to discuss your particular situation with a professional tax advisor.

How lost wages benefits are determined

Lost wages can be paid in different ways depending on how long you are injured and how severe the injury is. If the claim is open, the payment will be calculated differently than if the claim is closed.

Temporary total disability is the most common payment of lost wages. Also referred to as time-loss compensation, it is paid shortly after the injury for time you cannot work. In most states, this amount is calculated by taking two-thirds of your average weekly wage, which is calculated using your previous 52 weeks of wages.

In some states, while the claim is still open, you can receive temporary partial disability payments, such as if you were able to return to light-duty work for less than your normal working rate. The partial disability payment would be a portion of the difference between your average weekly wage prior to the injury and after the injury.

If your claim is closed but it has been determined that you have a permanent disability, you are eligible for permanent disability payments. This works the same way as temporary total disability payments; however, depending on the state, the permanent payments may be less than the amount you received while the claim was open. When someone has a permanent disability, they are more likely to qualify for SSDI and SSI; thus, their disability payments from workers' compensation will be considered taxable income. Depending on their total income, the benefits may be taxed.

Image Credit: Halfpoint / Getty Images
Kimberlee Leonard
Kimberlee Leonard Contributing Writer
Kimberlee has spent the past 20 years either directly involved in insurance and financial services or writing about it. She’s a former Series 7 and 65 license holder and former State Farm agency owner. As a small business insurance expert, her work can be found on Fit Small Business and Thimble.