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Are Workers’ Compensation Settlements Taxable?

The United States has one of the most comprehensive and sophisticated workers’ compensation systems in the world. Compared to the health insurance and unemployment benefits systems, workers’ compensation is a straightforward method to manage the ever-present risk of injury in the workplace.

In a nutshell, workers’ compensation is a form of income that is made available to claimants injured in the workplace or while performing duties related to their specific jobs. The compensation is made by means of an insurance system that is managed by a regulatory agency in each state of the union.

Employers cannot do business until they make workers’ compensation insurance premium payments into the system, and the state agency handles the claims and payouts process. Through this system, business owners and employers can pay attention to doing business instead of having to worry about the potential liability of on-the-job injuries or illnesses.

Taxation Status of Workers’ Compensation Payments

Although workers’ compensation distributions are considered income, they are not generally taxable. Most of the time they may not need to be reported on the 1040 form as part of the income tax return. There are some exceptions, however, when the Internal Revenue Service (IRS) may look at workers’ compensation as a taxable item.

Taxpayers who receive Social Security disability insurance at the same time they receive workers’ compensation payments will be taxed based on the difference between both amounts. This situation may arise if the health condition of a taxpayer who was injured in the workplace fails to improve; if the worker becomes disabled, he or she may receive disability insurance and workers’ compensation payments at the same time. When this happens, the Social Security Administration will reduce its payments to a certain level and the difference created by the workers’ compensation paycheck becomes taxable.

Supplemental Security Income, Settlements and Retirement

A situation similar to the one above would result if the injured worker receives supplemental security income on top of workers’ compensation. Payments coming from Social Security would be reduced and the difference created by the payment of workers’ compensation would be taxable. In most cases, however, this amount could be small enough to be negligible for taxation.

If the compensation claim was held up due to a lawsuit and the court approves a settlement, an accountant or tax attorney may need to structure the payment for the purpose of minimizing taxation. This also goes for situations in which a taxpayer decides to retire at the same time he or she is still receiving workers’ compensation payments.

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