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Disability can happen to anyone at any time – whether due to an accident, illness, or prolonged medical condition. What’s worse, most people find out – usually when the disabling event occurs – that their benefits aren’t nearly as generous as they had believed. Not because of the terms of the policy, but because of taxes. This doesn’t have to be the case! Make sure employees know the rules and take steps to preserve the full benefits they are expecting when the unexpected happens. In the past, most employers provided long term disability and employees could purchase short term outside of the employer environment. Now, it’s more likely that the employer will provide both short term and long term for employees. While that may sound like a good deal for employees, it’s not. If the employee becomes disabled, Internal Revenue Service (IRS) rules kick in to determine who paid the premium for coverage and if the premiums were paid with taxed or untaxed dollars. So, why does the IRS care about disability payments? It’s just like insurance – right? Not exactly. Disability payments are income-replacement policies, and taxes must be paid on wages. The benefits received from a disability policy are subject to employment withholding taxes. The tax rules are even different for the type of policy. Short Term Disability Short term disability benefits generally start fairly soon after the disability or illness occurs. Employment tax, or Social Security, is paid on all benefits received the first six months following the date of disability. This also means that the employer may be liable for its portion of Social Security taxes on short term disability payments. Long Term Disability Long term disability typically has a longer waiting period before benefits start. Benefits paid after six months following the last day of work will not incur Social Security taxes, but can be susceptible to federal income tax. It’s all in the planning before disability strikes. Insuring Tax-Free Benefits Most employees would like to receive their disability benefits on a tax-free basis. So how can employees reach this goal? By guaranteeing that premiums for disability policies are paid with taxed dollars. There are a couple ways an employee can do this. Let’s say that John works for a company that provides long term disability benefits. There is no “buy-up” option available to John; in fact, John doesn’t even know the total cost of his coverage. To ensure that any disability benefits received from this policy are not taxed, John decides to pay his premiums directly to the insurance carrier. Although this is simple, it may cause too many problems. The insurance company may not allow separate premium dollars under a list bill invoice. Or, the contract may be noncontributory, meaning it has to be 100 percent employer-paid. A direct, and still very simple, method would be for John to write his disability premium payment check to his employer each month. In effect, John is reimbursing his employer for the coverage with taxed dollars. The employee may even have to show the canceled checks if proof is ever required. In one court case, a statement signed by employees attesting to this type of arrangement was enough. The employer may also help employees with this tax dilemma. In the previous example, the employer could take it a step further and gross up the employee’s salary in the amount of the reimbursement check. The employer can also be the conduit for premium payments to the carrier. The employer can continue to pay the disability premiums and include this amount in the employee’s taxable income, thereby grossing up the employee’s salary. The arrangement could be as effortless as adding the annual premium amount to an employee’s W-2 wages at the end of the year. The good news is that the IRS has already approved these methods to eliminate taxes on disability payments. Several Private Letter Rulings (PLRs) have been issued by the IRS. Although PLRs are only binding for the taxpayer requesting clarification, they are a good indication of how the IRS views particular situations. Three-Year Look-Back Rule There are employment arrangements in which the employer and employees split the cost of the disability premiums. This may result in part of the premium being paid with pre-tax dollars and the remainder being paid with taxed dollars. A three-year look-back rule would apply to benefits received from such an agreement. Premium payments would be divided into taxed and untaxed categories, with a percentage of total premiums applied to each type. Those percentages would then apply to the benefits received. For example, if premiums over a three-year period totaled $15,000 and the employer paid $10,000 attributable to a non-taxable benefit, two-thirds of the benefit would be taxed when received. Keep the Facts Straight To make sure that everyone is on the right course, keep written documentation of the intent and methodology of disability payments. Here are the relationships that may affect the taxability of disability benefits:
When in doubt, talk with a competent tax attorney to launch a disability program that will result in a better benefit to employees.
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