No one wants to have to pay taxes if they can help it, but no sane individual wants to be in trouble with the IRS either. It is for this reason that many injured employees worry about what to do with workers’ compensation awards when they are given either through settlement or judge order.
Are these awards taxable, or is the employee receiving this money tax-free? We have asked attorney Alaina Sullivan, about what you should do. Here is what she had to say:
General Rule of Thumb
Normally, workers’ compensation benefits are not considered taxable income for both state and federal taxes. This rule gives a great deal of relief to many employees considering filing for workers’ compensation benefits. However, like so many rules of life, exceptions do exist to the rule.
The trick is to know what these exceptions are and realize how they affect the taxpayer. It is always encouraged that the injured employee not only work with a qualified workers’ compensation attorney but also an accountant, who can advise him or her on how this award will affect other aspects of his or her life.
Social Security and Workers’ Compensation Benefits
The situation gets tricky when the individual not only receives workers’ compensation benefits but also disability benefits through either Social Security Disability insurance (SSDI) or Supplemental Security Income (SSI).
What that individual receives through either SSDI or SSI may be reduced by a certain amount to keep the combined total below a specific threshold, otherwise known as the workers’ compensation offset.
Because of this offset, the amount of workers’ compensation that is considered taxable is the same amount by which SSDI or SSI is reduced.
If the Social Security Administration lowers the recipients SSI check by $200 to keep the combination of social security benefits and workers’ compensation benefits below a threshold, the $200 that the individual receives because of workers’ compensation would be considered taxable.
This problem rarely arises because most people who receive both SSI and SSDI and workers’ compensation do not make enough income to owe federal taxes, but it is important to know the limits and that they exist.
When Does the Offset Apply?
The offset applies if the individual is receiving social security disability benefits and workers’ compensation benefits, and the combined amount of these is over 80 percent of the individual’s average current earnings.
So what are these average current earnings? They can be calculated through the following:
- The average monthly wage used to calculate the individual’s workers’ compensation benefits;
- 1/60th of the person’s total wages for the highest-earning five previous years in a row; or
- 1/12th of the person’s total wages from the highest earning years out of the preceding five years.
It is the Social Security portion of the payments that are lowered to keep the combined total below the 80 percent threshold. Some states, albeit only a few, take the amount from workers’ compensation instead.
Social security will also take out legal fees, past and future medical costs, payments to dependents and any other expenses from the workers’ compensation amount before calculating the offset. Make sure the attorney is aware before entering into a workers’ compensation settlement agreement that SSI or SSDI payments are being received.
Structuring the Settlement
A workers’ compensation attorney can help the employee in properly structuring the settlement to reduce the amount of taxable income of the workers’ compensation settlement.
He or she can make sure the settlement is written in a way that minimizes the amount of the workers’ compensation offset, thus reducing the amount of taxes paid. The mostly commonly used way to do this is to have the agreement state that the lump sum should be spread throughout the life of the employee.
He or she still gets a “lump sum,” but it is considered to cover the remainder of the employee’s lifespan through actuarial tables. This division is different than periodic payments so make sure that it is identified as such in the agreement and make sure the monthly payments are designated, as well.
Contact an Attorney Today
If you have been involved in an accident during the normal course of business and are unsure about how to proceed with a workers’ compensation claim, it is highly recommended that you contact an attorney to answer your questions.
A licensed attorney trained in workers’ compensation law will be able to review your case and determine your best course of action. To receive the compensation you deserve, contact an attorney in your area today.