An injured employee's first money question is usually "How much will I get?" The second, often asked a few weeks later when the first check arrives, is "Do I owe taxes on this?" The short answer is that workers' compensation benefits paid under a workers' comp law are not taxable income. The longer answer, and the one HR needs, is that almost everything the employer adds around those benefits is taxable: salary continuation above the statutory benefit, top-up pay, PTO used to fill the gap, light-duty wages and benefits from an employer-paid disability plan.
That is where HR policy changes the answer. This post covers the federal rule, how top-ups and offsets change the tax picture, how to explain it to an injured employee and what payroll needs from HR to get it right. For the broader claim process, see our workers' compensation guide.
Internal Revenue Code section 104(a)(1) excludes from gross income "amounts received under workmen's compensation acts as compensation for personal injuries or sickness." The regulation under it, Treas. Reg. 1.104-1(b), extends the exclusion to benefits paid under a statute "in the nature of" a workers' comp act, and to compensation paid to the survivors of a deceased employee.
IRS Publication 525 puts it in plain terms: amounts received as workers' compensation for an occupational sickness or injury are fully exempt from tax if they are paid under a workers' compensation act or a statute in the nature of a workers' compensation act.
The same rule holds for employment taxes. IRS Publication 15-A says payments made under a workers' compensation law because of a work-related injury or sickness are not sick pay and are not subject to employment taxes. So statutory wage-loss benefits paid by the carrier, the state fund or a self-insured employer under the WC law carry no federal income tax withholding, no Social Security or Medicare tax and no W-2 reporting.
Three limits on that rule are worth knowing:
That third limit is the one HR policy runs into.
Statutory wage-loss benefits replace only part of an employee's pay, and the share and caps are set by each state. Many employers choose to close the gap. They do it in a few ways, and the tax treatment follows the source of the money.
The employer pays the difference between the WC benefit and the employee's regular pay, or some portion of it. The carrier's check stays nontaxable. The employer's top-up is not paid under the WC act, so it is taxable wages: subject to income tax withholding, Social Security and Medicare, and reported on the W-2.
Example: An employee's regular weekly pay is $1,000, and the carrier pays a weekly wage-loss benefit of $650 under the state act. The employer's policy tops up to full pay with a $350 weekly payment. The $650 is excluded from income. The $350 is wages, processed through payroll like any other pay.
Some employers, especially public employers and some larger private ones, keep paying the employee's full salary through payroll during the claim and arrange to receive the WC benefit back from the carrier, or have it assigned to them. This is where mistakes happen. The employee receives one paycheck, but part of it may stand in for the WC benefit and part is the employer's supplement.
How much of that paycheck is excludable depends on how the arrangement is structured and documented, and on the state law that governs it. Some public employee statutes qualify as "in the nature of" workers' comp and some do not; Publication 15-A explains the test for those statutes. Before you tell employees on salary continuation that their pay is tax-free, have payroll and a tax adviser confirm the treatment. The default assumption, that anything paid through payroll is wages, is often right but not always.
When an employee returns to light or modified duty, the pay for that work is wages. Publication 525 says salary payments for performing light duties after returning to work are taxable as wages. If the employee also receives a partial wage-loss benefit from the carrier because light-duty pay is lower, that benefit stays nontaxable.
PTO and sick pay are wages whenever they are used, including during a WC absence. If your policy lets or requires employees to use PTO during the waiting period, or to supplement the WC benefit, that PTO is taxable through payroll. Check your state's workers' comp and leave rules before requiring PTO use during a WC absence, and make sure your policy says clearly whether PTO use is optional. Also confirm how PTO use interacts with FMLA designation if the absence also qualifies.
Most employer STD and LTD plans offset workers' comp benefits, paying only the difference (if any) between the plan benefit and the WC benefit. The tax treatment of what the plan does pay depends on who paid the premiums. Publication 525 says employees must report as income amounts received for personal injury or sickness through an accident or health plan paid for by the employer; if both employee and employer pay, only the part due to the employer's payments is income. Benefits from a plan the employee paid for with after-tax dollars generally are not taxable.
So an employee on a WC claim may receive a nontaxable WC check and a taxable STD supplement in the same month. Make sure your plan administrator, payroll and the employee know which is which.
For employees on long-term claims who also receive Social Security disability benefits, federal law (42 U.S.C. 424a) generally reduces the Social Security benefit when combined workers' comp and Social Security disability benefits exceed 80 percent of the worker's "average current earnings," as the statute defines it. Where a state's WC law itself provides for reducing WC benefits in that situation, and did so on February 18, 1981, the federal reduction does not apply (42 U.S.C. 424a(d)). Publication 525 adds a tax wrinkle: if part of the workers' comp reduces Social Security benefits, that part is treated as Social Security benefits and may be taxable. Refer employees to the Social Security Administration and Publication 915 for their situation; HR's job is to know the offset exists and not give individual tax advice.
Injured employees see one or more deposits and want to know what is happening. A short written explanation at the start of the claim prevents most confusion and complaints. Include:
Avoid promising that "all your money during the claim is tax-free." That is the sentence employees remember in April.
Payroll can only treat payments correctly if HR tells it what each payment is. Set up a standard handoff at the start of every claim:
Give payroll a single contact on the HR side for the claim, and update it whenever the claim status, benefit amount or work status changes.
The federal exclusion is the same everywhere, but the facts around it vary by state:
Check with your carrier, your state workers' comp agency and your payroll provider before you write or change a supplement policy. The workers' comp training for HR page lists webinars on state-specific claim handling.
Tax questions are one of many things an injured employee brings to HR during a claim. The Workers' Compensation Training & Certification program covers the rest of the employer's role: identifying and reporting injuries, communicating with employees and insurance representatives, benefits and the claims process, medical restrictions and return to work, how premiums are determined and the injury and employment records you need to keep. It is online and self-paced, with a year of access, free updates when the law changes and an optional exam for the Certified Workers' Compensation Administrator credential.
Workers' comp benefits paid under a state or federal workers' compensation law for an occupational injury or sickness are not taxable for federal income tax purposes. IRC 104(a)(1) excludes them, and IRS Publication 15-A says they are not subject to employment taxes. The exception is anything paid beyond the statutory benefit: employer top-ups, salary continuation above the WC amount, PTO and light-duty wages are taxable wages.
Statutory workers' comp benefits paid by the carrier or state fund are not wages and do not go on the W-2. Anything the employer pays through payroll during the claim, such as top-up pay, PTO, light-duty wages or a salary supplement, is reported on the W-2 like other wages. If the employer runs full salary continuation and is reimbursed by the carrier, payroll and a tax adviser should confirm how that arrangement is reported.
Usually, at least in part. Treas. Reg. 1.104-1(b) excludes amounts paid under a WC act but not amounts in excess of what the act provides. If the employer pays full salary and part of it stands in for the WC benefit, how much is excludable depends on how the arrangement is structured and the state law behind it. Confirm the treatment with payroll and a tax adviser before telling employees.
Yes. A top-up is paid by the employer under its own policy, not under the workers' comp law, so it is taxable wages subject to income tax withholding and Social Security and Medicare taxes. The carrier's WC benefit remains nontaxable. Payroll should process the top-up as a separate earnings code so it is easy to track during the claim.
Yes. PTO and sick pay are wages whenever they are paid, including during a WC absence. If an employee uses PTO to cover the waiting period or to supplement the WC benefit, it is taxed through payroll like regular pay. Check your state's rules on requiring PTO use during a WC absence, and make sure your policy says whether it is optional.
It can. Under 42 U.S.C. 424a, Social Security disability benefits are generally reduced when combined workers' comp and Social Security disability benefits exceed 80 percent of the worker's average current earnings, as defined in the statute. A narrow exception applies where a state's WC law provides its own reduction. IRS Publication 525 notes that the part of workers' comp that reduces Social Security benefits is treated as Social Security benefits and may be taxable. Employees should contact SSA for their own figures.
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