Workers' comp benefits are tax-free unless you also receive Social Security disability benefits. If you're getting Social Security disability, there is one situation where part of your workers' compensation benefits may be taxed: if your disability benefits have been offset by your workers' comp benefits.
When Social Security Benefits Are Offset
In many states, receiving workers' compensation benefits can reduce ("offset") your Social Security Disability (SSDI) benefits. This happens only if the combined amount of your workers' compensation benefits and your disability benefits is greater than 80% of what your "average current earnings" were before you became disabled. (There are ways to reduce how much your Social Security benefits will be reduced by your workers' comp benefits; see our article on how much workers' comp lowers Social Security benefits.)
When the Offset Is Taxed
If your Social Security disability benefits were offset because of your workers' comp payment(s), the amount by which your Social Security payment was lowered is actually taxable income, even though you're still receiving the money as workers' compensation money (because you might have received the money as Social Security, and Social Security benefits are subject to taxation).
For example, if you are due $1,125 in Social Security and $575 in workers' comp benefits, for a total of $1,700 per month, your Social Security benefits will be offset if your average current earnings were over $2,125 per month ($1,700/$2,125 = 80%). If your average earnings were only $2,000, say, then your Social Security benefit will be reduced by $125, leaving you with $1,000 from Social Security. In that case, $125 of your workers' comp benefit is subject to tax.
However, to complicate things further, Social Security benefits aren't always taxable. Social Security benefits are only taxable if you earn too much income over the course of a year. If your “combined income” is over a certain amount ($25,000 for a single person and $32,000 for a married couple), you'll be taxed on your Social Security benefits. Your combined income is half of the Social Security benefits you received during the year plus all of your other income. For the details on calculating when you'll owe Social Security taxes, see Nolo's article on how Social Security benefits are taxed.
Note that in a few states, your workers' compensation benefits are reduced due to the offset rather than your Social Security benefits, in which case you're not taxes on any portion of your workers' comp benefits (and this only if the sum of your workers' comp benefits and your disability benefits is greater than 80% of what your earnings were).
Bottom line, most people won't have to pay taxes on workers' comp benefits, and if they do, the tax should only be on a small portion of their workers' comp payment.