Taxing Workers Comp

In Anthony M. Flores and Sandra L. Flores v. Commissioner (TC Summary Opinion 2005-57), the court considered whether certain workers’ compensation benefits were taxable as if they were Social Security benefits.

Usually a taxpayer can exclude workers’ compensation from his or her gross income but may be required to include Social Security benefits, including disability benefits. A statutory formula considers several factors, including the amount of the taxpayer’s Social Security benefits, other income and filing status, to determine whether he or she must pay taxes on this amount. However, when taxpayers receive workers’ compensation rather than Social Security disability benefits and this compensation reduces the amount of Social Security they receive, the workers’ compensation is taxed at the same rate as Social Security benefits.

Mrs. Flores was seriously injured at work in October 2000 and received workers’ compensation benefits from November 2000 through 2002.

At the time of her injury, Mrs. Flores also was covered by her employer’s long-term disability policy. Under the terms of the policy, employees who are disabled for more than a year must apply for Social Security benefits; in July 2002 Mrs. Flores applied for such benefits. Beginning in October 2002, she received Social Security benefit payments of $8,820—of which $6,772 represented back payments for the year 2001.

When Mrs. Flores received her Form SAA-1099, Social Security Benefit Statement, for 2002, the benefits reported totaled $20,675. This included the $8,820 Social Security benefits and $11,855 of workers’ compensation benefits. She excluded the $11,855 of workers’ compensation as “not paid by SSA” because she believed the workers’ compensation offset was not includable in taxable income.

The IRS issued a notice of deficiency stating the Floreses should have included the workers’ compensation in their income. The IRS noted that generally workers’ compensation benefits are not taxable under IRC section 104(a)(1). However, IRC section 86(d)(3) states when these benefits are paid in place of wages lost as a result of a work-related accident or injury and reduce Social Security or Railroad Retirement benefits received, they may be taxable. In these instances, the same method used to compute the taxable portion of Social Security and Railroad Retirement benefits is used to compute the taxable portion of workers’ compensation benefits.

Mrs. Flores argued she was required to apply for Social Security disability benefits under her long-term disability policy. If she had not, she would not have had to pay federal income tax on her workers’ compensation benefits under IRC section 104(a)(1), which would have allowed her to report the amount as compensation for personal injuries or sickness.

Result. For the IRS. The court examined the rationale for IRC section 86(d)(3). A review of the legislative history revealed it was meant to equalize the federal tax treatment of Social Security benefits whether the taxpayer was or was not eligible to receive workers’ compensation benefits. Under this section the $11,855 offset identified on Mrs. Flores’s 2002 form 1099-SSA—although not paid directly to her as Social Security benefits—was taxable. Although she received more than $11,855 in workers’ compensation, IRC section 86(d)(3) treats workers’ compensation benefits as though they were Social Security benefits only to the extent of the offset amount.

CPAs with clients receiving workers’ compensation benefits should inquire whether such benefits are received in lieu of Social Security disability benefits. If so, they must compute the taxable portion of workers’ compensation benefits in the same way as the taxable portion of Social Security and Railroad Retirement benefits is computed.

Anthony M. Flores and Sandra L. Flores v. Commissioner, TC Summary Opinion 2005-57.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.