Workers’ Comp and Taxes

What is workers’ compensation insurance?

Workers’ compensation insurance is a policy that provides financial and medical benefits to employees who experience job-related injuries or illnesses. It is mandatory for employers in most U.S. states. 

Each state where workers’ compensation insurance is mandatory has its own laws and regulations governing workers’ comp, so coverage and program requirements vary throughout the country. For example, in Alabama, business owners must offer workers’ comp insurance if they have five or more regular employees, whereas in Idaho, you need just one employee — who could be occasional, seasonal, part-time or full-time — to be subject to the mandate. 

The workers’ compensation insurance program is designed so that workers receive the care and financial support they need as they recover from a job-related injury or illness. During their time away from work, the insurance benefit covers a portion of the employee’s lost wages as well as their medical expenses.  

Usually, a business owner’s policy won’t cover workers’ comp; business owners will need a separate policy. [Learn about the types of business insurance your company may need.]

How does workers’ compensation work?

When an employee experiences illness or an injury due to work, they must report it to their employer. The employer then files a claim to the compensation insurance provider. Next, the insurer assesses the claim. If the insurer approves the claim, the insurer pays for the employee’s medical treatment and lost wages as the employee recovers. Employers do not need to contribute financially to this compensation, but they do have to pay for workers’ compensation insurance. They can deduct the cost as a standard business expense.

Workers’ compensation insurance operates on a no-fault basis. Employees don’t have to prove that their employer was negligent to receive compensation, and unless the employee rejects the settlement offered by the insurer, the employer is protected against being sued for the illness or injury. 

However, if the business owner was grossly negligent, the injury was caused by intentional misconduct or the employer deliberately violated safety regulations, the employee could seek a greater financial payout by suing the employer instead of filing a workers’ compensation claim.

Is workers’ compensation tax deductible for employers?

For employers, the premiums paid for workers’ compensation insurance are tax-deductible expenses. In general, when insurance is deemed ordinary and necessary, a business owner can deduct the cost. 

The IRS guide on deducting business costs defines an ordinary expense as something “common and accepted in your trade or business.” As such, any business can consider a workers’ compensation insurance policy a normal business expense. Additionally, because workers’ compensation is often deemed necessary by law, it is a deductible expense on this front, too.

Are workers’ comp benefits taxable for employees?

When employees can’t return to work due to job-related injuries, they will receive both medical benefits and lost-wages benefits through workers’ comp while they’re on disability leave. Although the medical benefits are paid directly to the medical providers offering treatment and aren’t taxable, the lost-wages benefits may be taxable under certain circumstances. 

In most cases, the lost-wages benefits are not taxable. This is true as long as the employee is not receiving federal Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI) on top of the lost-wages benefits. If they are receiving compensation from either of those sources, lost-wages benefits are taxable. 

Understanding how SSDI and SSI work

Both SSDI and SSI are federal disability programs offered through the Social Security Administration (SSA). Although both programs provide cash benefits, they are distinguished by their eligibility requirements set forth by the government. Because neither award is for temporary disabilities, most workers’ compensation cases will not lead an injured worker to file for either program.

To be eligible for SSDI, you must have an approved disability and have earned enough work credits throughout your career. There is a five-month waiting period for SSDI, and you become eligible for Medicare after two years. 

SSI is disability- and income-driven. According to the SSA, you can’t make more than $1,971 per month to be eligible for SSI. There is a one-month waiting period after SSI approval before payments can begin.

Both SSDI and SSI define disability in accordance with the SSA Code of Federal Regulations, which states that a disability is “the inability to do any substantial gainful activity by reason of any medically determinable or physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.”

Thus, to be eligible for either SSDI or SSI, the injury needs to prevent the worker from being able to do their job — or any other job — for at least 12 months. 

If you are injured and end up qualifying for SSDI or SSI, you’ll need to include your workers’ comp payments on your tax return. These payments become federally taxable with the first dollar you receive from either of these compensation programs. State laws vary, so it’s best to discuss your specific taxability with a professional tax advisor.

Importance of workers’ comp insurance

As far as business liability insurance goes, workers’ compensation insurance is essential for both employers and employees. Workers’ comp coverage benefits business owners and their team members in different ways, but overall, it enhances the employer-employee relationship and the working environment. 

Importance of workers’ comp insurance for employers

Workers’ compensation is an essential insurance policy for employers. It is not only required in most states (unless you qualify for a workers’ comp exemption) but also helps businesses prevent costly lawsuits for staff injuries sustained on the job. Without workers’ comp, your business may need to pay an exorbitant amount out of pocket to an injured employee. Most employers don’t have the resources to cover such costs without insurance. 

Also, if not having workers’ comp means you are violating a state law, your company could be in legal jeopardy. While insurance is an upfront expense, you are hedging that, in the long run, it is in your business’s best interest financially and legally to proactively protect itself. Of course, this is the case with all insurance policies; you pay insurance premiums now in the event you’ll need the coverage later.

Importance of workers’ comp insurance for employees

While not all workplace accidents can be prevented and some occupations pose higher risks than others, workers’ compensation insurance gives employees confidence that their employer will take care of them financially if an accident happens on the job. 

A workers’ compensation policy assures employees that there will be funding for medical expenses and lost wages if they are hurt while working. Many employees who get hurt incur thousands of dollars of medical costs and may be away from work for an extended period of time while recuperating. Provided that their employer has workers’ comp insurance and the claim is approved, they needn’t worry about their finances during that time.

How lost-wages benefits are determined

Lost wages can be paid in different ways depending on how long the employee has been injured and how severe the injury is. Open and closed workers’ compensation claims are calculated differently. 

Temporary total disability is the most common lost-wages payment because it’s the amount paid shortly after the injury occurs, compensating the employee for the time they can’t work. It’s also referred to as “time-loss compensation.” In most states, this amount is calculated by taking two-thirds of your average weekly wage, which is the average of your previous 52 weeks of work compensation. 

In some states, while the workers’ comp claim is still open, you can receive temporary partial disability payments. This would happen if you could return for light-duty work for less than your normal working rate. The partial disability payment would be a portion of the difference between your average weekly wage prior to and after the injury. 

If your claim is closed but it’s been designated that you have a permanent disability, you become eligible for permanent disability payments. This works the same way as temporary total disability payments, but depending on the state, the permanent payments may be less than you were getting while the claim was open. 

When someone has a permanent disability, they are more likely to become eligible for SSDI and SSI. As a result, they will likely see their lost-wages payments from workers’ compensation added to their tax returns. Depending on their total income, these benefits may be taxed. 

Mark Fairlie contributed to this article.