Question: How are employer-sponsored disability plan benefits taxed?
Short Answer: Disability benefits are taxable if the insurance premium was non-taxable to the employee in the year of the disabling event. On the other hand, disability benefits are non-taxable if the insurance premium was taxable to the employee during the year of the disabling event.
Disability Benefits Taxation: General Rule
Internal Revenue Code (IRC) §104, §105, and §106 govern the taxation of employer-sponsored disability coverage and benefits. These sections provide flexibility to employers in determining how to tax disability benefits.
Unlike medical benefits, there is no blanket exclusion from income for disability coverage and benefits. Rather, the disability plan tax rules generally provide that either the premium (cost of coverage) or benefit payments will be taxable to the employee.
How disability benefits are taxed when an employee becomes disabled depends on how the premiums were taxed during the year of the disabling event.
There are three possibilities:
- Non-Taxable Premium = Taxable Benefit: If in the year of the disabling event the disability plan cost of coverage paid by the employer (if any) is tax-free, and the disability plan cost of coverage paid by the employee (if any) is contributed on a pre-tax basis through the Section 125 cafeteria plan, the plan benefits paid to the disabled employee are taxable.
- Taxable Premium = Non-Taxable Benefit: If in the year of the disabling event the disability plan cost of coverage paid by the employer (if any) is taxable, and the disability plan cost of coverage paid by the employee (if any) is contributed on an after-tax basis, the plan benefits paid to the disabled employee are excluded from taxable income.
- Combination Taxable/Non-Taxable Premium = Pro Rata Taxation: If in the year of the disabling event the disability plan cost of coverage is partially tax-free (e.g., tax-free employer-share) and partially taxable (e.g., after-tax employee-share), the plan benefits paid to the disabled employee are taxable on a pro-rata basis calculated using a three-year look-back period.
For an overview of these options, see our ABD Taxation of Disability Benefits Guide.
Why Is the Tax Structure for Disability Plans Different from Health Plans?
IRC §105(b) provides that health benefits are excluded from income regardless of whether the cost of coverage was also excluded from income under §106. Hence, group health plan coverage (§106(a)) and benefits (§105(b)) are both excluded from income. Unfortunately, that supremely favorable tax-advantaged treatment for health plans does not apply to disability benefits.
IRC §104(a)(3) and §105(a) include identical language providing that disability benefits are included in gross income (i.e., taxable) only if they:
- “are attributable to contributions by the employer which were not includible in the gross income of the employee,” or
- “are paid by the employer.”
To understand these provisions requires an explanation of what constitutes “contributions by the employer”. This language does not refer to the standard employer contribution or employee contribution that is colloquially used in employee benefits jargon. Rather, it refers to the more formal legal definition of an employer contribution.
Under the more nuanced reading of what constitutes an “employer contribution” from IRS guidance, the following unintuitive structure applies:
- Pre-Tax Employee Contributions = Employer Contributions: Employee pre-tax contributions to the disability plan are treated as an employer contribution for tax purposes; and
- Taxable Employer Contributions = Employee Contributions: Employer taxable contributions (regardless of whether there is a gross up) are treated as an employee contribution for tax purposes.
The result is that despite the somewhat confusing statutory language, only employer non-taxable and employee pre-tax contributions to disability coverage result in taxable disability benefits.
Disability Benefits Taxation: Employer Options in Tax Design
Based on the IRS guidance described above, employers can utilize a wide variety of different approaches in how to handle this disability plan benefit tax structure.
The most common approaches are as follows:
- Employer-Paid Tax-Free Premiums: Benefit is Taxable
- Employer-Paid Taxable Premiums (No Gross Up): Benefit is Non-Taxable
- Employer-Paid Taxable Premiums (Gross Up): Benefit is Non-Taxable
- Employee-Paid Pre-Tax Contributions: Benefit is Taxable
- Employee-Paid After-Tax Contributions: Benefit is Non-Taxable
- Combination Employer-Paid Taxable and Employee After-Tax Contributions: Benefit is Non-Taxable
- Combination Employer Tax-Free and Employee Pre-Tax Contributions: Benefit is Taxable
- Combination Employer Tax-Free and Employee After-Tax Contributions: Pro-Rata Taxation Calculated Using Three-Year Look-Back Period
- Combination Employer Taxable and Employee Pre-Tax Contributions: Pro-Rata Taxation Calculated Using Three-Year Look-Back Period
For an overview of these options, see our ABD Taxation of Disability Benefits Guide.
Disability Benefits Taxation: Gross-Up Payments
Many employers choose to gross up the tax liability caused by taxable employer disability plan contributions to ensure that all disability plan participants will receive tax-free disability benefits without adverse tax consequences resulting from the cost of coverage. This gross-up approach does not affect the tax-free treatment of disability benefits.
Disability Benefits Taxation: Employee Tax Choice Arrangements
Many employers offer employees the ability to choose the tax treatment of the disability plan premium. For example, employees may choose whether to include in taxable income the employer’s payment of the cost of disability plan coverage (resulting in tax-free benefits) or exclude from taxable income the employer’s payment of the cost of disability plan coverage (resulting in taxable benefits).
These tax choice elections are permitted, provided:
- The tax choice election is made prior to the start of the plan year for an ongoing participant;
- The tax choice election is made on a prospective basis applicable to the remainder of the plan year for a mid-year newly eligible participant (e.g., new hires); and
- The tax choice election is irrevocable for the duration of the plan year once the period of coverage begins.
Important Note: Unlike the Section 125 rules, there are no permitted election change events that would allow a mid-year change to the tax choice election.
Disability Benefits Taxation: Short-Term and Long-Term Disability Plans
Although these tax design issues are most commonly applied to long-term disability plans because of the dramatic tax advantages that can result from receiving long-term disability benefits on a tax-free basis (and because some states already impose statutory short-term disability programs through payroll taxes), IRS guidance confirms that the same rules apply both to employer-sponsored short-term and long-term disability plans.
(a) In general.
Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—
(3) amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer)
(a) Amounts attributable to employer contributions.
Except as otherwise provided in this section, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.
Prop. Treas. Reg. §1.125-1(r)(2):
(r) Employer contributions to a cafeteria plan.
(2) Salary reduction as employer contribution. Salary reduction contributions are employer contributions. An employee’s salary reduction election is an election to receive a contribution by the employer in lieu of salary or other compensation that is not currently available to the employee as of the effective date of the election and that does not subsequently become currently available to the employee.
IRS Revenue Ruling 2004-55:
The Employer amends the plan (the Amended Plan) to provide that the Employer will continue to pay the long-term disability coverage on a pre-tax basis for eligible employees. However, each eligible employee may also irrevocably elect to have the Employer pay for the long-term disability coverage on an after-tax basis (i.e., elect to be taxed currently on the premiums paid by the Employer). An employee’s election applies to the entire cost of the coverage that the Employer pays to the third-party insurance carrier, so that an employee may not elect after-tax treatment for only a portion of the premiums. If an employee elects after-tax treatment, the Employer allocates the appropriate proportion of the group premium to that employee and includes that amount in the employee’s gross income for the year in which the payments are made (i.e., the premiums are reported on the employee’s Form W-2 for that year).
Under the Amended Plan, the employee’s election to pay for the cost of long-term disability coverage on an after-tax basis is irrevocable once the plan year begins and must be made prior to the beginning of the plan year in which the election becomes effective. The employee has the ability to make a new irrevocable election for each plan year prior to the beginning of that plan year. In lieu of a new election for each plan year, the Employer may provide that an employee’s prior election, once made, continues from one year to the next unless affirmatively changed before the beginning of the new plan year. The Employer may also provide that the long-term disability premiums will automatically be included in the employee’s gross income for the year unless the employee affirmatively elects otherwise prior to the beginning of the new plan year. Under the Amended Plan, an employee who becomes eligible for long-term disability coverage during a plan year (e.g., a newly hired employee) may make an irrevocable prospective election for the remainder of that plan year.
In addition, when a plan that provides long-term disability benefits is amended as described above, the Amended Plan is a new plan in computing the contributions of the Employer and the employees. With respect to each employee, the Amended Plan is financed either solely by the Employer or solely by the employee. At no time is the coverage under the Amended Plan financed by both Employer and employee contributions. Therefore, the Amended Plan is not a contributory plan within the meaning of § 1.105-1(c)(1) and, because the Amended Plan is not described in § 1.105-1(c)(1), the “three-year look back rule” set forth in § 1.105-1(d)(2) does not apply.
Finally, the applicable statutes and regulations do not distinguish between short-term and long-term disability plans. Thus, if an employer offers both short-term and long-term disability plans and permits employees to separately elect the contribution payment method for each plan, the law does not require aggregation of the contributions paid for each plan in determining the taxation of benefits. Benefits paid under a short-term or long-term disability plan will be taxed according to the contribution payment election made for each type of coverage.
Under the Amended Plan, long-term disability benefits received by an employee who has irrevocably elected, prior to the beginning of the plan year, to have the coverage paid by the Employer on an after-tax basis for the plan year in which the employee becomes disabled are attributable solely to after-tax employee contributions and are excludable from the employee’s gross income under § 104(a)(3).
Under the Amended Plan, long-term disability benefits received by an employee whose coverage is paid by the Employer on a pre-tax basis for the plan year in which the employee becomes disabled are attributable solely to pre-tax Employer contributions and are includible in the employee’s gross income under § 105(a).
These holdings are equally applicable to short-term disability benefits.
IRS PLR 200146010:
Long-term disability benefits paid to an employee who has elected, under the Amended Plan, to pay his or her own premiums for basic (and if applicable, supplemental) coverage on an after-tax basis for the Plan year in which he or she becomes disabled, are attributable solely to after-tax employee contributions and excludable from such employee’s gross income under section 104(a)(3) of the Code.
IRS PLR 200204021:
Under the Amended Plan, Employer will continue to make the premium payments for the disability insurance for each participant and then include the amount of the premium paid, in each participant’s taxable wages in the year the payments are made. Additionally, Employer will provide each participant with a one-time cash payment equal to the approximate additional tax resulting from the inclusion of the amount of the premium payments in taxable wages.
Participants in the Amended Plan will have long-term disability benefits that are attributable to contributions by the employer which will be included in the gross income of participants. Effectively, therefore, Employer is acting as a conduit for the payment of premiums for the long-term disability coverage by the participants with after-tax dollars.
Based on the information submitted and the representations made, we conclude as follows:
(1) Long-term disability coverage purchased under the Amended Plan will not be attributable to contributions by Employer for purposes of section 104(a)(3) and 105 of the Code.
(2) The long-term disability benefits received by participants covered under the Amended Plan will be excludable from the participants’ gross income under section 104(a)(3) of the Code.
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).