Federal Taxation

As with group life insurance, employer contributions for an employee's disability income insurance are fully deductible to the employer as an ordinary and necessary business expense under Code Section 162 if the employee's overall compensation is reasonable. Sick-leave payments are similarly tax deductible. Contributions by an individual employee are considered payments for personal disability income insurance and are not tax deductible.

Income Tax Liability of Employees
In contrast to group life insurance, for which employer contributions may result in some taxable income to an employee, Code Section 106 provides that employer contributions for disability income insurance result in no taxable income to an employee. However, the payment of benefits under an insured plan or sick-leave plan may or may not result in the receipt of taxable income. To make this determination, it is necessary to look at whether the plan is fully contributory, noncontributory, or partially contributory.

Fully Contributory Plan
Under a fully contributory plan, the entire cost is paid by employee contributions and benefits are received free of income taxation.

Noncontributory Plan
Under a noncontributory plan, the entire cost is paid by the employer and benefits are included in an employee's gross income. However, the Internal Revenue Code provides a tax credit to persons who are permanently and totally disabled. A tax credit is subtracted from an individual's federal income tax liability, not deducted from gross income. For purposes of this tax credit, the IRS uses the Social Security definition of disability; that is, an employee must be unable to engage in any kind of gainful work because of a medically determinable physical condition that has lasted or is expected to last at least 12 months or is expected to result in death.

The maximum credit is $750 for a single person, $1,125 for a married person filing jointly, and $562.50 for a married person filing separately. The credit cannot exceed the taxable disability benefit actually received. The maximum credit is reduced if a single individual has an adjusted gross income (including the disability benefit) over $7,500, if a married person filing jointly has an adjusted gross income over $10,000, or if a married person filing separately has an adjusted gross income over $5,000. The reduction is equal to 7½ percent of any income over the limit. In addition, the credit is reduced by 15 percent of any tax-free income received as a pension, annuity, or disability benefit from certain government programs, including benefits from Social Security. Because disability income plans are usually integrated with Social Security, the tax credit available to most persons who receive disability benefits from employer plans is substantially reduced or eliminated altogether.

Partially Contributory Plan
Under a partially contributory plan, benefits attributable to employee contributions are received free of income taxation. Benefits attributable to employer contributions are includable in gross income, but employees are eligible for the tax credit described previously.

The portion of the benefits attributable to employer contributions (and thus subject to income taxation) is based on the ratio of the employer's contributions to the total employer-employee contributions for an employee who has been under the plan for some period of time. For example, if the employer paid 75 percent of the cost of the plan, 75 percent of the benefits would be considered attributable to employer contributions and 25 percent to employee contributions. The time period used to calculate this percentage varies, depending on the type of disability income plan and the length of time that the plan has been in existence. Under group insurance policies, the time period used is the three policy years ending prior to the beginning of the calendar year in which the employee is disabled. If coverage has been in effect for a shorter time, IRS regulations specify the appropriate time period to use. Similar provisions pertain to contributory sick-leave plans, the major exception being that the time period is based on calendar years rather than policy years. If benefits are provided under individual disability income insurance policies, the proportion is determined on the basis of the premiums paid for the current policy year.

Tax Withholding and Social Security Taxes
Benefits paid directly to an employee by an employer under a sick-leave plan are treated like any other wages for purposes of tax withholding. Disability income benefits paid by a third party (such as an insurance company or a trust) are subject to the withholding tax rules and regulations only if the employee requests that taxes be withheld. In both cases, benefits that are attributable to employer contributions are subject to Social Security and Medicare taxes. However, taxes are payable only during the last calendar month in which the employee worked and the six months that follow.