Little known fact about the SSDI off-set

Medicare Set-Aside Blog on May 6, 2011
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I have long questioned the tax exemption of workers’ compensation indemnity payments. Really what is the likelihood of incentive to return to work when you can obtain 2/3s of your previous salary tax free without having to lift a finger. Then if you can prove that you are unable to do any work, you may be able to also get SSDI and get up to 80%. Now while I was aware that SSDI was taxable to a certain degree, there’s a little catch I was unaware of.

Now no one pays federal income tax on more than 85 percent of his or her Social Security benefits. There is a sliding scale that goes something like this:
[Note that =Your “combined income” = Your adjusted gross income + Nontaxable interest + 1/2 of your Social Security benefits]

If you file a federal tax return as an “individual” and your combined income is between $25,000 and $34,000:
you may have to pay income tax on up to 50 percent of your benefits.
more than $34,000, up to 85 percent of your benefits may be taxable.

If you file a joint return, and you and your spouse have a combined income that is between $32,000 and $44,000:
you may have to pay income tax on up to 50 percent of your benefits.
more than $44,000, up to 85 percent of your benefits may be taxable.

If you are married and file a separate tax return, you probably will pay taxes on your benefits.

The catch comes in when an SSDI beneficiary is also entitled to workers’ compensation benefits. Standing alone, workers’ compensation benefits are not included in gross income pursuant to IRC § 104(a)(1). Between the two programs, the Social Security Act requires that Disability benefits be reduced so that combined, benefits do not exceed 80 percent of the workers’ average current earnings. While there are some states that permit the workers’ compensation benefits to be reduced to meet that limit, the vast majority of the country utilizes the federal government reduction.  IRC § 86(d)(3) basically states that if some portion of the SSDI benefit was paid by workers’ compensation, what we generally call an off-set, then the workers’ compensation payment equal to the reduction of the SSDI benefit is included in the “social security benefit” for tax purposes.  So while the government does not have to pay the benefit, it still has the luxury of taxing you on it.

On April 6, 2011, the Tax Court in Sherar v. Commissioner determined that petitioner did in fact owe taxes on the portion of her SSDI not paid by Social Security. While the Court acknowledged that workers’ compensation is generally excludable from gross income pursuant to section 104(a)(1), because she applied for and was granted SSDI benefits, the amount of the off-set was includable in gross income. Had she not applied for SSDI, regardless of doing so only upon the advice of her attorney, she would have continued to receive all of her workers’ compensation benefits tax free.

Moral of the story is:  the only sure things in life are death and taxes; nothing in this life is free; be careful what you wish for…*
[Let us not forget that if Petitioner now desires to settle her workers’ compensation claim that she’s also now going to have to consider Medicare’s interests]

Sherar v. Commissioner of Internal Revenue
T.C. Summary Opinion 2001-44
United States Tax Court
Filed April 6, 2011

* Note:  The above is not tax advice.  For specific advice on this issue, consult your tax advisor.