2.13 Workers’ Compensation Is Tax Free
You do not pay tax on workers’ compensation payments for job-related injuries or illness. However, your employer might continue paying your regular salary but require you to turn over your workers’ compensation payments. Then you are taxed on the difference between what was paid to you and what you returned.
EXAMPLE
John Wright was injured while at work and was out of work for two months. His company continues to pay his weekly salary of $775. He also receives workers’ compensation of $200 a week from the state, which is tax free. He gives the $200 back to his employer. The balance of $575 a week is considered taxable wages.
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Caution
Job-Related Injury or Illness
Not all payments for job-related illness or injury qualify as tax-free workers’ compensation. Unless the statute or regulation authorizing your disability payment restricts awards to on-the-job injury or illness, your payment is taxable. Even if your payments are in fact based upon job-related injury or illness, they are taxed if other individuals can receive payments from the plan for disabilities that are not work related; see Example 1 (2.13).
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To qualify as tax-free workers’ compensation, the payments must be made under the authority of a law (or regulation having the force of a law) that provides compensation for on-the-job injury or illness. Payments made under a labor agreement do not qualify as tax-free workers’ compensation.
A retirement pension or annuity does not qualify for tax-free treatment if benefits are based on age, length of service, or prior plan contributions. Such benefits are taxable even if retirement was triggered by a work-related injury or sickness.
State law may impose a penalty for unreasonable delay in paying a worker’s compensation award. If the penalty is considered to have the remedial purpose of facilitating the injured employee’s return to work, the IRS may treat the penalty as part of the original tax-free compensation award.
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Court Decision
Is Sick Leave Tax-Free Workers’ Compensation?
According to the Tax Court, sick leave may qualify as tax-free workers’ compensation if it is paid under a specific workers’ compensation statute or similar government regulation that authorizes the sick leave payment for job-related injuries or illness; see Examples 2, 3, and 4 (2.13).
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EXAMPLES
1. Kane, a federal district judge, suffered from sleep apnea, a condition characterized by a cessation of breathing during sleep, which was aggravated by the stress of his judicial work. He received a retirement disability payment of $65,135.
A federal appeals court held that the payment was taxable because it was paid under a statute which did not specifically require that the payments be for work-related injuries. Here, the federal law under which the judge received his payments provided benefits for all permanent disabilities, whether or not job related.
2. A teacher, injured while working, received full salary during a two-year sick leave. She argued that the payments, made under board of education regulations, were similar to workers’ compensation and thus tax free. The IRS disagreed; the regulations were not the same as a workers’ compensation statute. The Tax Court supported the teacher. The payments were made because of job-related injuries and were authorized by regulations having the force of law.
3. The IRS claimed that a police officer in Lynbrook, N.Y., was subject to tax on line-of-duty disability pay because the payment was under a labor agreement with the Police Benevolent Association (PBA). The Tax Court supported the police officer’s claim that the payments were authorized by a specific New York State law requiring full salary for job-related police injuries. The PBA agreement did not affect the officer’s rights to those state law payments. Lynbrook treated the case as a workers’ compensation claim and in fact received reimbursement from the state workers’ compensation board for the payments made to the officer.
4. A Los Angeles sheriff injured on the job retired on disability and, under the Los Angeles workers’ compensation law, was allowed to elect sick pay in lieu of the regular workers’ compensation amount because the sick pay was larger. The IRS argued that the sheriff had merely received taxable sick pay because he would have received the same amount as sick pay if his injuries had been suffered in a personal accident. However, the Tax Court allowed tax-free treatment. The sick leave was paid under a workers’ compensation law that applied solely to work-related injuries. The fact that sick leave may also have been available to other employees under other laws does not mean that it may not be included as an option under a workers’ compensation statute.
The IRS announced that it does not agree with the Tax Court’s decision allowing full tax-free treatment. According to the IRS, benefits up to the regular workers’ compensation amount should be tax free but excess amounts should be taxed.
Effect of workers’ compensation on Social Security.
In figuring whether Social Security benefits are taxable (34.2), workers’ compensation that reduces Social Security or equivalent Railroad Retirement benefits is treated as a Social Security (or Railroad Retirement) benefit received during the year. Thus, the workers’ compensation may be indirectly subject to tax (34.2).
