Do You Have to Pay Taxes on a Workers Comp Settlement?

Workers’ compensation settlements provide financial relief to individuals injured or made ill in the workplace. These settlements typically cover medical expenses, a portion of lost wages, and compensation for permanent impairment resulting from the work-related incident.

General Tax Rule for Workers’ Compensation Settlements

Workers’ compensation benefits, including settlements, are generally exempt from federal income tax. This exemption applies because these payments are considered compensation for physical injuries or sickness sustained due to a work-related incident. Federal tax law, specifically Internal Revenue Code Section 104, excludes from gross income amounts received under workers’ compensation acts as compensation for personal injuries or sickness.

This tax-free status holds true whether the settlement is received as a single lump sum or as periodic payments. The funds are intended to restore the injured individual to their pre-injury financial state. Core components of a workers’ compensation settlement, such as payments for medical care and compensation directly related to the physical injury, typically remain untaxed. This allows injured workers to use their settlement funds to address the direct financial consequences of their work-related injury without an additional tax burden.

Taxable Components of a Settlement

While the primary components of a workers’ compensation settlement are generally tax-exempt, certain elements within a settlement can be subject to taxation. These exceptions occur when the payment does not directly relate to compensation for physical injury or sickness.

If a workers’ compensation settlement includes an amount specifically designated for lost wages that are not directly attributable to the physical injury or sickness, or if it represents a “wage replacement” payment distinct from the physical injury compensation, that portion might be taxable. This often arises when a settlement includes payments for wages that would have been earned regardless of the injury itself. The Internal Revenue Service distinguishes between compensation for the injury and compensation for economic losses not directly tied to the physical harm.

Any interest earned on a workers’ compensation award or settlement is generally taxable. If there is a delay in payment and the settlement includes an additional amount as interest for that delay, this interest component is considered ordinary income. This interest is typically reported to the recipient on Form 1099-INT by the payer and must be included in the recipient’s gross income.

Punitive damages, though rare in workers’ compensation cases, are typically taxable if they are awarded. Punitive damages are intended to punish the wrongdoer rather than compensate the injured party for losses, so they do not fall under the tax exemption for physical injury compensation. Similarly, compensation for emotional distress not linked to a physical injury or sickness may also be taxable, although this is less common in standard workers’ compensation settlements.

How Settlements Are Structured and Reported

The way a workers’ compensation settlement is structured significantly impacts its tax treatment. A detailed settlement agreement that clearly allocates the funds to specific categories, such as medical expenses, lost wages directly resulting from the physical injury, or compensation for permanent impairment, helps support the tax-exempt status of those portions. Without clear allocation, the Internal Revenue Service may question the tax-free nature of certain payments.

For the portion of a workers’ compensation settlement that is tax-exempt, typically no tax forms like a Form 1099-MISC are issued to the recipient. This is because these amounts are not considered taxable income and therefore do not require reporting to the Internal Revenue Service by the payer.

If any portion of the settlement is determined to be taxable, as discussed previously, the recipient is responsible for reporting it. For instance, taxable interest income would be reported on Schedule B of Form 1040, or if reported on a Form 1099-INT, it would be entered directly on the tax return. Other taxable components, such as certain lost wage payments or punitive damages, might be reported as “other income” on Schedule 1 of Form 1040.

Attorney fees paid from a workers’ compensation settlement also have specific tax considerations. If the fees are paid from the tax-exempt portion of the settlement, they do not reduce the tax-exempt amount received by the individual. However, if attorney fees relate to a taxable portion of the settlement, they might be considered miscellaneous itemized deductions. For tax years after 2017, these miscellaneous itemized deductions are generally not deductible for individuals, though specific rules may apply if the fees are paid directly to the attorney and the taxable income is reduced by that payment.