Published December 02, 2010
Dear Tax Talk,
I am a municipal employer in the state of Florida. We pay 100% of an individual's regular pay when they are out on workers' compensation. They endorse over to the city any payments they receive from a third-party insurance company for workers' comp. My question is, what amounts, if any, paid by us are tax-exempt to the employee? Or, is the payment fully taxable? Is there a six-month time frame (or other time frame) whereby the payments are taxable and then become tax-exempt after the six-month waiting period? Thank you.
When it comes to payroll taxes, the law is precise and oftentimes seems contradictory. The general rule is that workers' compensation benefits are tax-exempt to the recipient. Payments made to a worker under a disability policy are taxable if the premiums are paid by the employer. Well, workers' compensation insurance is paid by the employer and is paid to an employee for disability -- so why should it be tax-exempt?
The primary reason is that collecting workers' comp benefits means that the disabling injury is work-related. Because workers' comp is only a fraction of the employee's wages, to subject it to taxation would further erode the worker's earnings. By exempting the benefits from taxation, the tax law attempts to make the employee whole again.
Disability insurance is paid without regard to the nature of the disabling injury. The benefits are taxable even if the injury was work-related. However, most disability policies will attempt to collect under workers' compensation for a work-related injury.
Special rules apply to municipalities where the worker may or may not be covered by a workers' compensation law. State and local government employees, such as police officers and firefighters, sometimes receive payments due to an injury in the line of duty under a statute that is not the general workers' compensation law of a state. If the statute limits benefits to work-related injuries or sickness and does not base payments on the employee's age, length of service or prior contributions, the statute is "in the nature of" a workers' compensation law. Payments under a statute in the nature of a workers' compensation law are not subject to employment taxes.
Based on your short question, I'm not sure I have all the facts to provide a definitive answer in your case. I recommend you consult a professional tax adviser familiar with all your facts before exempting the payments. The following are examples from the Internal Revenue Service regulations section 31.3121(a)(2)-1 that may be helpful.
A local government employee is injured while performing work-related activities. The employee is not covered by the State workers' compensation law, but is covered by a local government ordinance that requires the local government to pay the employee's full salary when the employee is out of work as a result of an injury incurred while performing services for the local government. The ordinance does not limit or otherwise affect the local government's liability to the employee for the work-related injury. The local ordinance is not a workers' compensation law, but it is in the nature of a workers' compensation act. Therefore, the salary the employee receives while out of work as a result of the work-related injury is excluded from wages under section 3121(a)(2)(A).
The facts are the same as in Example 1 except that the local ordinance requires the employer to continue to pay the employee's full salary while the employee is unable to work due to an injury whether or not the injury is work-related. Thus, the local ordinance does not limit benefits to instances of work-related disability. A benefit paid under an ordinance that does not limit benefits to instances of work-related injuries is not a statute in the nature of a workers' compensation act. Therefore, the salary the injured employee receives from the employer while out of work is subject to FICA even though the employee's injury is work-related.
The facts are the same as in Example 1 except that the local ordinance includes a rebuttable presumption that certain injuries, including any heart attack incurred by a firefighter or other law enforcement personnel, is work-related. The presumption in the ordinance does not eliminate the requirement that the injury be work-related in order to entitle the injured worker to full salary. Therefore, the ordinance is a statute in the nature of a workers' compensation act, and the salary the injured employee receives pursuant to the ordinance is excluded from wages under section 3121(a)(2)(A).
Ask the adviser
To ask a question on Tax Talk, go to the "Ask the Experts" page and select "Taxes" as the topic. Read more Tax Talk columns.
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.