Revenue Ruling 85-105, citing Reg. Sec 1.104-1(b), states that disability retirement payments made to a taxpayer - under a workmen’s compensation act or under a statute in the nature of a workmen’s compensation act - as compensation for personal injuries or sickness incurred during employment may not be subject to federal income tax.

Retirement payments are not taxable if they are received pursuant to a workers’ compensation act or a statute in the nature of a workers’ compensation act. However, such payments are not excludable to the extent they are determined by reference to the employee’s age or length of service or prior contributions, even if the retirement occurs due to an occupational injury. (Reg. § 1.104-1(b)) The annual Form 1099-R issued by the former employer should reflect the portion of the retirement payments that is taxable.

The Court of Appeals for the Ninth Circuit has affirmed a Tax Court decision that a retired member of the Los Angeles County Sheriff's Department could not exclude from income the amount by which his retirement benefits exceeded the amounts that he was entitled to receive on account of his disability, finding that the excess was subject to tax under Reg. § 1.104-1(b) because it was calculated in reference to the taxpayer's length of service. The Court also rejected the taxpayer's challenge to the validity of that reg. (Sewards v. Comm., (CA 9 5/12/2015))

The exclusion for workers’ compensation applies to benefits paid under a workers' compensation act to the survivor or survivors of a deceased employee (Reg § 1.104-1(b), or under a statute which is in the nature of a workers' compensation act to the survivors of a deceased employee (Rev Rul 80-44). A statute authorizing benefits for employees' survivors can qualify as a statute in the nature of a workers' compensation act if it requires as a prerequisite to payment a determination that the cause of the employee's death was service-related.

However, continuation benefits paid to the surviving spouse of a deceased firefighter under a statute that didn't distinguish between job related and non-job-related disabilities weren't excludable. Although the benefits qualified as a continuation of the employee's benefits under Rev Rul 80-44, since the statute wasn't in the nature of a workers' compensation act, the spouse's benefits were a mere continuation of the deceased employee's taxable benefits and weren't excludable (IRS Letter Ruling 9445003).

The SECURE 2.0 Act Section 309 amends IRC Sec 139 to permit qualified first responders to exclude service-connected disability pension payments from gross income after reaching retirement age, effective in 2027. The term ‘qualified first responder retirement payments’ means, with respect to any taxable year, any pension or annuity which otherwise would have been includible in gross income for the taxable year in which the payment is received -