When you receive workers' compensation benefits, in most cases, you won't have to pay state or federal taxes on the money. It's 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 with a tax advisor when you receive workers' compensation benefits.
Here's a look at why workers' compensation insurance is important, how it works, and how to understand the tax implications of workers' comp benefits.
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Importance of workers' comp insurance
As far as business liability insurance goes, workers' compensation insurance is essential for both employers and employees. Workers' comp coverage benefits employers and employees in different ways, but overall, it enhances the employer-employee relationship and working environment.
Importance of workers' comp insurance for employers
The workers' comp policy pays medical benefits and lost wages to an employee who is injured while working. Workers' compensation is an essential insurance policy for employers to obtain. Not only is it required in most states (unless you qualify for a workers' comp exemption), but it also helps employers prevent costly lawsuits for injury claims on the job.
While there are variations to state laws about who must obtain workers' compensation and what constitutes a valid claim, most states require an employer with at least one employee to obtain insurance that will pay if an employee is hurt at work. Usually, a business owners policy won't cover workers' comp; you'll need a separate policy.
Workers' comp is no-fault insurance, meaning the injury doesn't have to stem from proven negligence to be a valid claim. In exchange for the no-fault designation, the employee can't sue an employer with a valid workers' comp policy, at least in most states.
Most importantly, the employer doesn't have to pay the injured employee's medical costs and lost wages. These costs can grow to tens of thousands – if not hundreds of thousands – of dollars. Most employers don't have the resources to cover these costs without insurance.
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 these laws coincided with an effort to help reform dangerous workplace environments so that workers would be safer and better protected.
While not all accidents can be prevented, and some occupations pose higher risks than others, workers' compensation insurance gives workers confidence that their employer will take care of them if an accident happens.
A workers' compensation policy assures employees that there will be funding for medical expenses and lost wages if they are hurt while working. Many employees who get hurt 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 paid for workers' compensation insurance are tax-deductible expenses. In general, when insurance is deemed ordinary and necessary, a business owner can deduct the cost.
The IRS guide on deducting business expenses defines an ordinary expense as something "common and accepted in your trade or business." Any business would then consider a workers' compensation insurance policy to be a normal business expense.
Since workers' compensation is considered necessary by law, it is also a deductible expense on this front.
Are workers' comp benefits taxable for employees?
When employees can't return to work due to work-related injuries, they will receive both medical benefits and lost wages benefits while they're on disability leave. While the medical benefits are paid directly to the medical providers offering treatment and aren't taxable, the lost wages benefits may be taxable under certain circumstances.
In most cases, the lost wages benefits 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) on top of the lost wages benefits. If they are receiving income from either of those sources, lost wages benefits are taxable.
Understanding how SSDI and SSI work
Both SSDI and SSI are federal disability programs offered through the Social Security Administration (SSA). While they both offer cash benefits, they are distinguished by their different eligibility requirements set forth by the government. Since neither are for temporary disabilities, most workers' compensation cases will not lead an injured worker to file for either program.
To be eligible for SSDI, you must have an approved disability and have earned enough work credits throughout 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. According to the SSA, as of January 2021, you can make a maximum of $7,770 per year to be eligible for SSI. There is a one-month waiting period after SSI approval before payments can begin.
Both SSDI and SSI define disability in accordance with the SSA Code of Federal Regulations, which states that a disability is "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 injury needs to prevent the worker from being able to work at their job – or any other job – for at least 12 months.
If you are injured and end up qualifying for SSDI or SSI, you'll need to include your workers' comp payments on your tax return. These payments become federally taxable with the first dollar you receive from either of these programs. State laws do vary, so it's best to discuss the taxability with a professional tax advisor.
How lost wages benefits are determined
Lost wages can be paid in different ways depending on how long you've been injured and how severe the injury is. Open and closed claims are calculated differently.
Temporary total disability is the most common lost wages payment because it's the amount paid shortly after the injury occurs, compensating for the time you can't work. It's also referred to as "time-loss compensation." In most states, this amount is calculated by taking two-thirds of your average weekly wage (AWW). The AWW is the average of your previous 52 weeks of work compensation.
In some states, while the claim is still open, you can receive temporary partial disability payments. This would happen if you could return for 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 and after injury.
If your claim is closed, but it's been designated that you have a permanent disability, you become 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 what you were getting while the claim was open.
When someone has a permanent disability, they are more likely to become eligible for SSDI and SSI. Thus, they will likely see their disability payments from workers' compensation be added to their tax returns. Depending on their total income, the benefits may be taxed.