The federal government and individual states provide injured employees with workers' compensation insurance benefits when they sustain job-related illnesses or injuries. Workers' compensation settlements and weekly payments are not subject to income taxes. Since workers' compensation benefits are not taxable, the Internal Revenue Service does not allow taxpayers to deduct their awards. However, business owners can deduct their workers' compensation taxes or payments to cover insurance premiums.
Generally, legal settlement awards are taxable and subject to federal taxation. Additionally, each state's tax agency can impose state income taxes on workers' compensation payments. Although the IRS typically requires taxpayers to include their legal settlement awards as taxable benefits on their tax returns, Congress provides an exception for certain types of settlement awards. According to the Internal Revenue Code, legal settlement awards and insurance payments are not taxable if they are intended to compensate victims for their physical injuries or illnesses. However, although physical injury awards are not taxable, punitive damage awards or emotional distress settlements are taxable.
Business Taxes
Business owners can deduct the costs of required insurance payments if they are necessary for their business operations. According to the federal tax code, incidental insurance payments are deductible expenses for employers as costs incurred in the ordinary course of business. Business owners can deduct the costs of their insurance payments on their Schedule C, Profits and Losses.
The IRS allows business owners to deduct the costs of workers' compensation insurance premiums that are required by state law and provide benefits to injured benefits without regard to fault. Since most states allow employers to waive self-coverage, employers who optionally purchase self-coverage can deduct the costs of their self-coverage premiums.
Exclusion From Income
Taxpayers can exclude their workers' compensation benefits from their annual tax returns but they may not deduct them. The IRS allows injured workers to exclude their wage replacement workers' compensation benefits if they were paid pursuant to state laws. Furthermore, the IRS limits the tax exclusion to workers' compensation awards. Thus, an employee who retires from his job because of a debilitating and permanent injury cannot deduct retirement pension payments or exclude his retirement benefits. If he does not receive workers' compensation benefits pursuant to his state workers' compensation system, he may not exclude his retirement benefits from his tax returns. However, if he stops working because of a permanent injury and retires pursuant to his state workers' compensation system, he can exclude his workers' compensation benefits.
Exceptions
The IRS requires taxpayers to count their workers' compensation benefits as income if they continue to work modified or light-duty shifts while receiving reduced weekly benefits. Under the Internal Revenue Code, these payments are not excluded benefits but a continuation of paid wages. Employees must pay income taxes on their wages.
Considerations
Since tax laws can frequently change, do not use this information as a substitute for legal advice. Seek advice through an attorney licensed to practice law in your state.