According to the Internal Revenue Service (IRS), in its Publication 907, workers’ compensation for an occupational sickness or injury, if paid under a workers’ compensation act or similar law, are not taxable. This includes lump sum settlement payments. Workers’ Compensation benefits are not taxable at the state, federal, or local levels. Although an employee is required to report workers’ compensation benefits on their New York W-2 tax documents, the benefit payment amounts are not included in the person’s gross pay.
The policy behind the tax exempt status of workers’ compensation benefits arises out of the fact that workers’ compensation benefits are considered to be non-taxable insurance settlements and such benefits only represent two-thirds (2/3rds) of the average weekly wage of the injured worker times the percent of his or her disability. The workers’ compensation laws were established to ensure financial compensation as well as medical benefits to employees who are injured in the course of their employment. The laws and the IRS tax code take into account that work-related accidents and injuries require more than just medical compensation and therefore it is a benefit to the families of injured employees that taxes are not taken out of their wage benefits. This way, families of people who are injured on the job and either cannot continue to work or have to work at a diminished financial capacity can still strive to pay their monthly bills until that person is fully recovered from the work related injury or receives a legal determination of a total permanent injury.
It is important to note that there are circumstances in which receiving workers’ compensation benefits do give rise to a taxable event. If an individual is receiving both Social Security Disability benefits and workers’ compensation benefits then the Social Security benefits may become taxable. If an individual were to receive both Social Security Disability benefits and Workers’ Compensation benefits, then a person can only receive up to 80% of his or her pre-disability earnings from both sources, otherwise the Social Security benefits will be reduced. In this situation, a person would be taxed by the IRS on the full amount of the Social Security benefits even if it has been reduced by Workers’ Compensation benefits. The IRS has outlined these procedures in its Publication 17.