Which of the following determines whether disability insurance benefits are taxed?

Give Your Employees a Choice:

Disability Benefits Can Be Taxable or Non-taxable!

The taxation of disability coverage and benefits can be complicated, but IRS guidance gives private employers flexibility in how to structure the taxation of these benefits.� This flexibility creates a "win-win" situation for employers and employees: Internal Revenue Service (IRS) guidance gives employers the ability to add employee choice to disability benefit plans without taking on any additional cost.� This article provides an overview of these rules.� In addition to these rules, governmental employers need to consider whether disability benefits are structured "in lieu of workers' compensation benefits" under state law.� This article does not cover those special rules.

1.                  Background

Depending on the structure of the disability plan, an employee may or may not be taxed on the value of disability coverage, and the tax treatment of the disability benefit can also vary.� The tax treatment of the benefit depends on whether the employee was taxed on the cost of coverage.� The taxation of coverage varies depending on whether it is funded by employee contributions, employer contributions, or both. �Because of these varying rules, employers have several options for how to set up disability benefit plans, depending the desired outcome for tax treatment of the benefit and how the coverage is funded.� In fact, recent guidance from the Internal Revenue Service authorizes employers to offer plans that permit employees to make a "front-end" choice about the tax treatment.�

Complicated rules apply if disability benefits under a plan are considered to be funded by both employee and employer contributions.� However, much simpler rules apply when the benefits are completely funded by either employee or employer contributions.� Offering a choice between these two options is now possible under IRS rules.�

2.                  Summary of IRS Guidance

In 2004, the IRS issued a ruling which discussed the tax treatment of disability benefits paid to an employee who was covered by long term and short-term disability insurance plans.� These plans offered two options regarding payment of the premiums.� In this ruling, the IRS determined that it was permissible for the disability plan to give employees the option to include in income the cost of the employer premiums for disability insurance coverage, and that this election would determine the taxation of the benefits. Previously, the employer-paid premiums were paid by the employer, but not taxed to the employee at the time they were paid.�

In this case, the employer's amendment to the disability plans (both short-term and long-term) gave employees the ability to elect to include in taxable income the employer-paid premiums for long term disability benefits. �According to the terms of the plan, the new election was made in the year prior to the plan year when it took effect.� The IRS also permitted a special election by an employee who became eligible for long term disability coverage in the middle of a plan year.� The special election would be effective prospectively for the remainder of that plan year.� The ruling also stated that the plan may provide that the premiums will automatically be included in gross income unless the employee affirmatively elects otherwise prior to the beginning of the new year, and that an employee's election will continue from year to year unless it is affirmatively changed before the beginning of the next plan year.

The IRS determined that, with respect to each employee, disability benefits are financed either solely by the employer or solely by the employee.� Accordingly, coverage under the plan was never provided by a combination of both employer and employee contributions, and the plan was determined not to be subject to complex rules regarding the allocation of costs and taxation of benefits.� In other words, the employee election in place at the time the employee becomes disabled will govern the tax consequences of the employee's disability benefits.

The 2004 IRS guidance is significant because it completes a movement away from the position taken in prior rulings.� In those ruling, the Service held that a long-term disability arrangement that was modified by converting from entirely employer paid to entirely employee paid was subject to complex rules regarding allocating costs of the coverage.�

3.                  Employer Opportunity

These rules give employers the ability to offer options for tax treatment of benefits to employees.� If the disability benefits are paid by the employer, then employers may let employees elect whether to include the cost of disability coverage in income.� This election gives employees control over whether any disability benefits they might later receive will be taxable or non-taxable.� Employers that are paying for disability benefit coverage for their employees may wish to use this process to permit elections regarding the taxation of the coverage, which results in no additional cost to the employer.� If employees are funding the costs of the disability benefits through a salary reduction plan, the employer may give a similar election to the employee by integrating the disability plan with the flexible spending plan.�

Please contact an Ice Miller employee benefits group attorney if you might be interested in taking advantage of these employee benefit planning opportunities for your disability plans under these IRS rules.�

Which of the following determines whether disability insurance benefits are taxable?

Which of the following describes taxation of an individual disability income insurance premiums and benefits?

Under what conditions are group disability income benefits received by an employee not taxable?

Which of the following is not correct concerning taxation of disability income benefits?