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J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return by J.K. Lasser Institute

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2.13 Workers’ Compensation Is Tax Free

You do not pay tax on workers’ compensation payments for job-related injuries or illness. However, your employer might continue paying your regular salary but require you to turn over your workers’ compensation payments. Then you are taxed on the difference between what was paid to you and what you returned.

EXAMPLE
John Wright was injured while at work and was out of work for two months. His company continues to pay his weekly salary of $775. He also receives workers’ compensation of $200 a week from the state, which is tax free. He gives the $200 back to his employer. The balance of $575 a week is considered taxable wages.
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Job-Related Injury or Illness
Not all payments for job-related illness or injury qualify as tax-free workers’ compensation. Unless the statute or regulation authorizing your disability payment restricts awards to on-the-job injury or illness, your payment is taxable. Even if your payments are in fact based upon job-related injury or illness, they are taxed if other individuals can receive payments from the plan for disabilities that are not work related; see Example 1 (2.13).
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To qualify as tax-free workers’ compensation, the payments must be made under the authority of a law (or regulation having the force of a law) that provides compensation for on-the-job ...

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