Workers' Compensation: Cost, Rates, and Tax Treatment
How premiums are rated by class code and payroll, what the employer deducts, and why benefits are tax-free to the worker
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
Workers' compensation insurance pays medical costs and lost wages for employees injured on the job, in exchange for the employee giving up the right to sue. Nearly every state but Texas requires it. Premiums are set per US$100 of payroll by occupational class and claims history; they are deductible to the employer, and benefits are tax-free.
On this page
How is the premium calculated?
| Factor | How it works |
|---|---|
| Class code | Each job is assigned a classification (roofer, clerical, plumber, landscaper) with a base rate per US$100 of payroll set by the state's rating bureau or the insurer; a roofing class might run US$15–US$30 per US$100, clerical under US$0.50 |
| Payroll | Estimated annual payroll by class, audited after the policy year (the audit adjusts the premium up or down to actual payroll) |
| Experience modification factor | A multiplier (1.00 is average) based on the employer's claims over the prior three years relative to expected losses for its size and classes; a mod of 0.80 cuts the premium 20 percent, a 1.30 raises it 30 percent — applied to employers above a premium threshold |
| Schedule credits and debits | Insurer adjustments for safety programs, drug testing, and similar factors |
| State assessments and minimum premiums | Fixed charges and a minimum per policy |
Premium = (payroll by class ÷ 100) × class rate × experience mod ± credits. Owner-officers can often exclude themselves or include themselves at a capped payroll figure; sole proprietors and partners are generally excluded unless they elect in. Independent contractors with their own coverage are excluded from the employer's payroll — but a "contractor" the state deems an employee is added at audit, with premium due on their pay.
Who must carry it?
Requirements vary by state: some require coverage from the first employee, others from three, four, or five employees; construction trades often face stricter rules (coverage from the first worker, including certain contractors); Texas makes it optional but exposes non-subscribers to lawsuits. Many customers require it by contract regardless — a general contractor's subcontract, a property manager's vendor agreement, a school district's service contract — with a certificate of insurance as the proof. A sole proprietor with no employees is typically not required to carry it but may need a policy (or a state waiver) to satisfy a customer's requirement.
What is the tax treatment?
For the employer: premiums are an ordinary and necessary business expense, deductible in the year paid (cash method) or incurred, on Schedule C line 15 (insurance) or the corporate equivalent; the audit adjustment is deducted or added in the year it is billed or credited. Deductibles and any self-insured retention paid on a claim are deductible when paid. For the employee: workers' compensation benefits for a work-related injury or illness are excluded from gross income entirely — medical payments, wage-replacement benefits, and lump-sum settlements alike — and are not reported on a W-2 or 1099. The exception is a benefit that offsets Social Security disability (the offset portion may be taxable as Social Security would have been) and any part attributable to a return-to-work wage paid by the employer, which is ordinary wages.
What does workers' compensation cost a small business?
Enough to change an entity or hiring decision. A landscaping crew at US$8 per US$100 on US$300,000 of payroll is US$24,000 a year before the experience mod; an office of the same payroll at US$0.40 is US$1,200. The trade guides on this site price it into every classification decision, because a crew paid as "contractors" skips the premium until the audit or the injury — and an uninsured injury is a claim against the business and, without a respected entity, the owner. The premium is also the reason the S election worksheet counts payroll costs correctly: workers' compensation runs on the crew's wages, not the owner's.
Worked example
A plumbing company has US$520,000 of payroll: US$460,000 in the plumbing class (US$6.20 per US$100) and US$60,000 clerical (US$0.35). The owner excludes himself. Base premium: (US$460,000 ÷ 100 × US$6.20) + (US$60,000 ÷ 100 × US$0.35) = US$28,520 + US$210 = US$28,730. Experience mod after three clean years: 0.88 — premium US$25,282, plus a 5 percent schedule credit for a documented safety program and a US$300 state assessment: about US$24,300, deductible on the 1120-S as insurance. At audit, the insurer finds US$40,000 paid to a "subcontractor" who worked only for the company on its trucks — reclassified, added to plumbing payroll, and US$2,480 of additional base premium — about US$2,070 after the mod and schedule credit — billed (deductible when paid). A journeyman's back injury the following year produces US$31,000 of medical and wage benefits — tax-free to him, paid by the carrier, and reflected in the company's next experience mod.
Frequently asked questions
How is workers' compensation premium calculated?
Payroll by occupational class code, divided by 100, times the class rate, times the employer's experience modification factor, plus or minus schedule credits and state assessments — with a year-end audit adjusting estimated payroll to actual.
Are workers' comp premiums tax deductible?
Yes — an ordinary and necessary business expense, deductible in the year paid or incurred, including audit adjustments and any deductibles paid on claims.
Are workers' comp benefits taxable?
No. Medical, wage-replacement, and settlement benefits for a work-related injury or illness are excluded from the employee's income, except to the extent they offset Social Security disability benefits.
Is workers' comp required for a sole proprietor?
Usually not by law when there are no employees, though state rules vary and construction trades are often stricter. Customers frequently require a policy or a state waiver by contract regardless.
Official sources
The IRS states: “You must deposit and report federal income tax and Additional Medicare Tax withheld and both the employer and employee social security and Medicare taxes.” — Internal Revenue Service, Employment taxes, https://www.irs.gov/businesses/small-businesses-self-employed/employment-taxes
The IRS states: “In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.” — Internal Revenue Service, Independent contractor (self-employed) or employee?, https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee
Next step
Fairlight Accounting is a cross-border accounting and tax practice with a U.S. Tax Desk and a Canadian Tax Desk. Our U.S. Tax Desk handles payroll cost modeling including workers' compensation by class, audit preparation and contractor classification review, and insurance expense treatment on business returns. See pricing or book a call.
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