BE AWARE OF TAX IMPLICATIONS OF EMPLOYER
PROVIDED DISABILITY BENEFITS
Many employers offer disability insurance as a fringe benefit to their employees. However, many employers are not aware of the complex tax laws associated with disability insurance. Disability benefits paid to the employee under the disability policy may or may not be taxable income to the employee. The determination may depend on whether the employer or the employee paid or was deemed to have paid the disability insurance premiums. Therefore, employers, in conjunction with their employees, must decide what portion, if any, of the value of the premiums paid will be included in the employee's wages. This decision determines how much of the insurance benefit received will be taxable to the employee.
- Disability benefits are taxable to the employee when the employer has paid the premiums at no taxable cost to the employee.
- Disability benefits are taxable to the employee if the employee pays the premium as part of a Sec. 125 cafeteria plan.
- Disability benefits are not taxable to the employee when the employee has either paid the premium directly or if the employer has included the value of the premium as part of the employee's taxable wages.
- Disability payments are partially taxable to the employee if the employer and employee have agreed to split the cost of the premium, in which case the taxable portion of the benefit will be the same ratio as the percentage of the premium the employer paid.
The purpose of disability insurance is to replace the wages of the employee during the time the employee is unable to work due to sickness or disability. Chances are only a small percentage of your employees will collect significant benefits under the policy. Thus, most employees prefer to let the employer pay the premium and ignore the potential for future income taxes.
Regardless of whether or not the benefits are subject to tax, both the insurance company and you, the employer, are required to coordinate the reporting of disability benefits paid to the employee. The taxable portion is subject to the third party sick pay rules. Taxable disability benefits paid during the first six months of the disability (short term disability benefits) are subject to FICA, Medicare and FUTA taxes as well as income tax withholding. Taxable disability benefits paid after the sixth month of the disability (long-term disability benefits) are not subject to FICA, Medicare and FUTA taxes, but are still subject to income tax withholding. It is important to ask your payroll service provider to delay processing your quarterly payroll taxes and Form W-2s until the third party sick pay information is available.
Please note that disability insurance is considered to be a form of health and accident insurance for tax purposes. Accordingly, more than 2% shareholders of S corporations should include the disability insurance premium on the shareholder's W-2.
Please contact Terry Martin, Tax Manager at 215-675-8364 or tmartin@wm-cpa.com to discuss the options available and how it will affect the tax liabilities of your employees and your company.
