Question: I own and operate a small business and am trying to determine how best to establish an insured disability insurance program for the company employees. If an employee becomes disabled and receives benefits from the insurance company, will the employee be taxed on the benefits received?
Answer: The taxation of disability insurance benefits depends upon who pays the premiums and how the premiums are paid. If an employer pays disability insurance premiums for an employee who becomes disabled, then the disability benefits will be taxed to the employee when received. If the employee pays the disability insurance premiums, then the disability benefits the employee receives will not be taxed to the employee. In some employer sponsored disability insurance plans, the premiums are shared by the employer and the employee. In these types of arrangements, the benefits received by the disabled employee will be taxed to the employee based on the percentage of the premium payments made by the employer.
The situation is slightly more involved if premiums are paid by an employee through a cafeteria plan, also known as a flexible benefits plan or a 125 plan. Cafeteria plans offer employees the option of applying their salary towards specified employee benefits on a pre-tax basis. Employees most commonly use cafeteria plans for health insurance premiums, out of pocket medical expenses and dependent care assistance costs. To the extent these benefits are paid through a cafeteria plan, the employee only pays income tax on the difference between the employee’s gross salary and the amount of cafeteria plan benefits paid for allowable benefits. For example, an employee earning $100,000 per year who pays the employee’s $5,000 share of health insurance premiums through a cafeteria plan will only be subject to income and payroll tax on the $95,000 difference between the two. Employers benefit as well from the arrangement as the obligation to match the employee’s share of payroll taxes only applies to the difference between the employee’s salary and the cafeteria plan benefits applied to allowable expenses.
If an employer offers disability insurance through a cafeteria plan, whether the disability benefits are short-term or long-term, then the employee can pay for disability benefits with pre-tax dollars. The result of course is that any insurance benefits which are received by the disabled employee will be taxed to the employee. The rationale for this treatment is that the pre-tax payments are, for tax purposes, deemed to have been paid by the employer.
The majority of taxpayers will not incur a long-term disability. For this reason, many employees given the choice through a cafeteria plan, will opt for the current tax savings and pay the disability insurance premiums with pre-tax dollars. A far greater number of workers will incur a short-term disability yet many employees still opt to pay policy premiums with pre-tax dollars in a cafeteria plan. Many employers do not offer disability insurance benefits through a cafeteria plan and will simply adopt the plan and pay for the benefits. Those employees who ultimately collect disability insurance benefits in a case like this will be disadvantaged as income tax costs can take a significant bite out of the disability benefits which are paid at a time when the employee may not have an opportunity to earn other income.
As an employer structuring a disability insurance plan for your employees, you will have a significant decision to make. If you want all of your employees to have disability coverage, you should pay for the plan for the employees as some employees will invariably choose not to pay for the coverage if given the choice to opt out of plan coverage. This will of course mean that the employees will pay tax on disability insurance benefits when paid. On the other hand, if you want employees to enjoy tax-free payments from disability insurance if they are disabled, you can offer a plan where employees pay the disability insurance premiums but are not permitted to pay with pre-tax dollars. This will permit employees to avoid the adverse tax impact they will face if a disability ensues.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfbbg.com.
