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Tax treatment of workers comp and disability benefits

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    The general rule is all items received constitute “gross income” and are taxed. However, IRC §104(a)(1) provides an important exception to this rule. Section 104(a)(1) excludes from gross income payments received under “workmen’s compensation acts as compensation for personal injuries or sickness.” In other words, one need not pay taxes on certain awards received for certain workmen’s compensation or disability benefits.

    Treasury Regulation § 1.104-1(b) states that to qualify for exclusion under Section 104(a)(1), a settlement or award must be made under a statute that is “in the nature of a workers compensation act,” and is for an injury “incurred in the course of employment.”

    This leads one to ask what it means for a statute to be “in the nature of a workers compensation act.” The answer is that the statue must contain specific language establishing a nexus between payments and on the job injuries or sickness. Wallace v. United States, 139 F.3d 1165 (1998). For example, the California Labor Code has numerous provisions which expressly state that certain payments are to be made on account of work place incidents resulting in injury or illness, temporary disability, permanent disability, and death.

    This implies that statues which do not have such a “nexus” or statues which fail to distinguish between work related and non-work related injuries not qualify as a workmen’s compensation acts within the meaning of Section 104(a)(1). Craft v. United States, 879 F. Supp. 925 (1995). Statues which have a dual purpose, where one of those purposes contains the requisite nexus between payments and work related injuries may still be considered within the nature of a workmen’s compensation, and amounts received under the statue will qualify for favorable tax treatment.

    The conclusion, therefore, is that the precise language and nuances of a statute are critical to determining whether disability payments received favorable tax treatment under Section 104(a)(1).

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