Is L&I Taxable Income? The Rules for Workers’ Comp

“L&I” refers to state Labor and Industries departments, which administer workers’ compensation benefits. These benefits provide financial support to employees for work-related injuries or illnesses, covering medical expenses, lost wages, and rehabilitation costs. This article clarifies whether workers’ compensation benefits are taxable income under federal and state tax laws. The information provided is for general understanding and does not constitute tax advice.

Taxability of Workers’ Compensation Benefits

Workers’ compensation benefits received for an occupational sickness or injury are generally not considered taxable income at the federal level. This non-taxable status applies whether benefits are received as weekly payments for lost wages, medical expenses, or as a lump-sum settlement. The Internal Revenue Service (IRS) views these payments as compensation for personal injury or sickness, which is excluded from gross income. Most states also exempt workers’ compensation benefits from state income tax, aligning with federal treatment. This means that in the majority of cases, neither federal nor state income tax is applied to these benefits.

However, there are specific scenarios where workers’ compensation benefits might indirectly lead to a portion of other income becoming taxable. This can occur when workers’ compensation is received alongside Social Security Disability Income (SSDI) or Supplemental Security Income (SSI). Federal regulations stipulate that the combined total of workers’ compensation and Social Security benefits generally cannot exceed 80% of an individual’s average earnings before the disability. If the combined benefits exceed this 80% threshold, the Social Security Administration (SSA) may reduce the amount of SSDI benefits received. This reduction, known as a “workers’ compensation offset,” can make a portion of the Social Security benefits taxable, even if the workers’ compensation itself remains non-taxable.

Reporting Workers’ Compensation on Tax Forms

Since workers’ compensation benefits are generally non-taxable, they typically do not appear on common tax forms such as a W-2 or a 1099-NEC. Employers and insurance providers are not usually required to issue these forms for non-taxable workers’ compensation payments. Therefore, if an individual is solely receiving workers’ compensation, they usually will not receive any tax notification documents for these benefits.

In rare instances, a Form 1099-MISC might be issued for workers’ compensation payments. This could happen for certain lump-sum settlements that include elements beyond pure wage replacement, or specific third-party payments. If a 1099-MISC is received, only the taxable portion, if any, should be included in gross income. The non-taxable portion should be identified as such and not reported as income.

Non-taxable workers’ compensation benefits do not need to be reported as income on Form 1040, the primary federal income tax return. However, for informational purposes, taxpayers may choose to note non-taxable income sources on Schedule 1 (Form 1040). This form is used to report additional income or adjustments. Non-taxable workers’ compensation benefits can be listed on Schedule 1, Part I, Line 8i, designated for “Other Income.” While not required, this provides a clear record of the non-taxable income received during the tax year and does not affect tax liability.

Impact on Other Income and Deductions

Receiving workers’ compensation benefits can interact with other income sources, particularly Social Security benefits. As explained, the “offset” rule means workers’ compensation payments can reduce the amount of Social Security disability benefits received if combined totals exceed a certain percentage of pre-disability earnings. When SSDI benefits are reduced due to this offset, the reduction can affect the taxability of the remaining Social Security benefits. Even though workers’ compensation itself is not taxed, the offset amount may be considered part of the Social Security benefits that become taxable if combined income thresholds are met.

Medical expenses related to a work injury or illness that are paid for by workers’ compensation cannot be claimed as a medical expense deduction on a tax return. Tax deductions for medical expenses are generally allowed only for out-of-pocket costs not reimbursed by insurance or other programs. Since workers’ compensation covers these medical costs, they do not qualify for a personal deduction.