Are My Workers’ Comp Benefits Taxable?

A few related questions our Colorado attorneys frequently get asked during the course of settlement negotiation and mediation of a workers’ compensation case is:

• Am I going to get taxed on the final settlement amount?
• Do I have to claim workers’ comp benefits as income when filing taxes?
• Are workers’ comp settlements taxable?

The short answer to all of these questions is no.

As with personal injury claims, benefits received through a state’s workers’ comp program (be it in Colorado or elsewhere) are not subject to either federal or state taxes. They aren’t taxed for a variety of reasons — one being the fact that they’re not considered “earned income” under current tax laws.

According to the IRS’ Publication 907, “Workers’ Compensation for an occupational sickness or injury if paid under a Workers’ Compensation act or similar law” is not taxable.

This generally applies to both structured weekly wage loss and lump sum payments.

The reasoning behind not taxing workers’ comp settlements goes something like this:

When you’re injured on-the-job and out of work, you’ll likely have to miss work. Any benefits you receive for lost wages are at a reduced rate from your normal pay.

Therefore, the IRS and the Colorado Legislature rightfully claim that it would be grossly unfair and unjust to require injured workers to pay taxes on these benefits.

This tax exemption also applies to benefits paid to any survivors under workers’ comp death benefits.

Exceptions: When Workers’ Comp Benefits CAN Be Taxed

If you return to work in a modified role during your recovery, keep in mind that any earnings from your job will be taxable since they are indeed “earnings” from working. The workers’ comp wage loss benefits you’re still receiving will not be taxed though.

While the answer to the question above is pretty straightforward for regular workers’ comp benefits, it gets slightly more vague and confusing if your benefits are combined with social security disability (SSDI) or some retirement plan. In short, any supplemental benefits you receive through Social Security Disability Insurance (SSDI), Supplemental Security Income (SSI) or another plan will be taxable at the applicable rate.

When an injured worker also receives disability benefits SSDI or SSI, the Social Security Administration (SSA) may reduce the individual’s SSDI or SSI payouts so that the combined amount of the workers’ comp benefits and the disability payments remains below a certain threshold. This is known as a “workers’ compensation offset.”

So, if SSA reduces your monthly SSDI check by $200 due to the workers’ compensation offset, then $200 of your workers’ comp will be taxable.

Any pension based on your age, years of service, etc. is also taxable. However, if part of that plan is paid through workers’ compensation, that part will not be taxed.

U.S. Court Rules that Injured Worker Benefits Cannot be Taxed

Some additional clarity on the relationship between SSDI, workers’ compensation, and taxes was handed down by a U.S. Tax Court in 2011. Their decision was based on whether workers’ comp benefits can be excluded from taxable income.

The case in question took place right here in Colorado and involved Linda Sherar. Mrs. Sherar sustained two major injuries requiring her to undergo 12 separate surgeries. She started receiving workers’ comp benefits in 1999 and applied for SSDI in 2003. Although her initial application was denied, she eventually started receiving SSDI benefits in 2007.

But when she received a statement from the Social Security Administration, Linda discovered a “workers’ compensation offset” but didn’t report any SSDI benefits as income. The IRS claimed that 85% of the SSDI benefits she received should have been included on her tax return as income.

While the tax court recognized the workers’ comp benefits as being not taxable, they concluded that SSDI benefits may “be includable in a taxpayer’s gross income pursuant to a statutory formula.”

They claimed that under section 86(d)(3), the amount of SSDI benefits may include the amount of workers’ compensation benefits received — meaning that “if the amount of Social Security benefits that a taxpayer receives is reduced because of the receipt of workers’ compensation benefits, there is what’s called an offset.”

With this offset, “the amount of workers’ compensation benefits that cause the reduction is treated as though it were a Social Security benefit.” Therefore, be careful when considering your options regarding SSDI and permanent disability.

When Should You Consult an Expert?

Of course, you should always consult an accountant or experienced workers’ comp attorney in Colorado to ascertain what, if any, taxes you will be responsible for. Don’t take this post or any other information you find online for granted. Do your own research and discuss your individual situation with a qualified professional.

In the end though, if you’re receiving straight workers’ comp benefits paid out by your employer’s insurance company, you don’t have to pay any taxes on those funds you receive.