Generally, workers' compensation is not taxable income. Per the IRS:
Amounts you receive as workers' compensation for an occupational sickness or injury are fully exempt from tax if They're paid under a workers' compensation act or a statute in the nature of a workers' compensation act. The exemption also applies to your survivors. The exemption, however, doesn't apply to retirement plan benefits you receive based on your age, length of service, or prior contributions to the plan, even if you retired because of an occupational sickness or injury.
If part of your workers' compensation reduces your social security or equivalent railroad retirement benefits received, that part is considered social security (or equivalent railroad retirement) benefits and may be taxable. See Pub. 554, and Pub. 915, Social Security and Equivalent Railroad Retirement Benefits, for more information.
Return to work. If you return to work after qualifying for workers' compensation, salary payments you receive for performing light duties are taxable as wages.
Disability pension. If your disability pension is paid under a statute that provides benefits only to employees with service-connected disabilities, part of it may be workers' compensation. That part is exempt from tax. The rest of your pension, based on years of service, is taxable as pension or annuity income. If you die, the part of your survivors' benefit that is a continuation of the workers' compensation is exempt from tax.
Other compensation. Many other amounts you receive as compensation for sickness or injury aren't taxable. These include the following amounts.
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Compensatory damages you receive for physical injury or physical sickness, whether paid in a lump sum or in periodic payments. See Court awards and damages under Other Income, later.
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Benefits you receive under an accident or health insurance policy on which either you paid the premiums or your employer paid the premiums but you had to include them in your income.
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Disability benefits you receive for loss of income or earning capacity as a result of injuries under a no-fault car insurance policy.
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Compensation you receive for permanent loss or loss of use of a part or function of your body, or for your permanent disfigurement. This compensation must be based only on the injury and not on the period of your absence from work. These benefits aren't taxable even if your employer pays for the accident and health plan that provides these benefits.
IRS Pub 525
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