In 2006, the vast majority of U.S. corporations offer quality group long-term disability coverage to their employees with a benefit level insuring to 60% of “income.”
As group LTD plans are written in boilerplate form, they frequently don’t adequately cover the needs of the more highly compensated senior management group.
Key executives at high levels of income also have to face the “Disability Tax Man” in higher tax brackets than most employees. So the need exists to limit corporate liability and offer alternatives that cover any gaps in disability coverage.
Consider ABC Manufacturing Inc., which offers a group LTD package covering all employees, with a top benefit of $10,000 a month. As premiums for the current group LTD plan are company paid (with benefits fully taxed when disabled), a $150,000/year salaried executive receives a $7,500/month benefit when totally disabled. After being taxed at 35% (adding federal and state income taxes) the executive gets to keep only $4,875/month after taxes, or 39% net.
How many executives and their families facing today’s inflationary economy can live on 39% of income for very long?
Avoiding the “disability tax man”
The high incomes of senior corporate executives necessitate competent tax planning during the working years. And, it’s just as important, maybe even more important, to seek proper tax counsel prior to a long-term disability.
How do we avoid the “Disability Tax Man” during periods of long-term disability?
Consider the tax alternatives. When premiums are paid personally, with after-tax dollars, benefits received are tax-free. [IRC Sec. 104(a)(3)]. When premiums are paid by the corporation and are deductible by the employer [IRC Sec. 162], benefits received are fully taxable [IRC Sec. 1059a)]
Let’s look at an example of an executive earning $150,000 (with $30,000 of normal tax deductions), or $120,000 taxable income. He’s eligible for disability benefits equal to 60% of his salary or $90,000 per year ($7,500 per month).
With the corporation deducting the cost of the LTD premiums, the executive will be fully taxed on $90,000 of disability payments. Assuming he still has $30,000 annually of tax deductions, his $90,000 of taxable disability payments will result in approximately $31,500 of payments to the Disability Tax Man. Who would want a permanent 35% reduction in their after-tax income over a prolonged period of total disability? So how do we best save corporate executives a severe tax burden when faced with a long-term disability without taking away the employer’s tax deduction on the LTD premiums paid?
IRS Revenue Ruling 2004-55
Employers can give their employees the opportunity to choose each year whether to pay short- and long-term disability premiums on a pre- or after-tax basis without causing the plan to be treated as a contributory plan under applicable Treasury regulations, according to Revenue Ruling 2004-55. This ruling confirms a position the IRS took in a private letter ruling and is most significant because it outlines a way employers can give their employees substantial flexibility to determine whether their short- or long-term disability benefits will be subject to tax.
Effect on employers
An annual election gives employees the flexibility to change their minds about paying disability premiums on a pre- or after-tax basis as they become more (or less) concerned about becoming disabled.
The revenue ruling offers a low-cost way for employers to enhance the value of their disability benefits as perceived by employees.
Note! The revenue ruling specifies that the choice must be made before the beginning of the plan year in which it becomes effective, and must be irrevocable once the plan year begins. Employers should be careful to explain to employees that the choice he or she makes for the year in which he or she first becomes disabled will decide how those benefit payments will be taxed regardless of what choices the individual may have made in prior years.
Employees can avoid taxes on disability insurance benefits by paying the premiums themselves with after-tax dollars, or by including the value of employer-paid premiums in income. IRC section 104(a)(3).
Another alternative is for the employer and employee to split the premium burden (i.e., a contributory plan). In the case of a contributory plan, an employee receiving disability benefits will pay tax on the portion of disability benefits attributable to the employer’s share of premium payments during the last 3 policy years, if known. (IRC section 105(a) and Treas. Reg. Sec. 105-1(c).) This is known as the “3-year look back rule.”
The IRS in PLR 200312001 ruled that the 3-year look back rule did not apply to a long-term disability plan that permitted employees to choose each year to pay premiums on a pre- or after-tax basis. According to that PLR, the tax treatment of benefit payments would depend on what election the employee made for the plan year in which he or she became disabled. If the employee had elected to pay premiums on an after-tax basis for that year, the benefit payments would not be taxable.
To illustrate the effects of this ruling, suppose an employer pays the annual LTD premium for each eligible employee in a plan on a pre-tax basis-that is, the premiums are not reported on the employee’s Form W-2 for that year. But the employer amends the plan to allow each eligible employee to make an irrevocable election before the start of every plan year to decide whether or not to have premium payments included in taxable income.
Employees in this plan can change whether they want premium payments included in taxable income in later plan years.
The plan is not contributory, so the 3-year look back rule does not apply.
In this case, when determining the tax treatment of benefit payments from the long-term disability plan, all that matters is the election the employee made for the plan year in which he or she becomes disabled.
If the employee had elected to pay taxes on the employer’s premium payments for that year, the benefit payments would not be taxable pursuant to IRC section 104(a)(3).
If the employee had elected to not pay taxes on the employer’s premium payments for that year, the benefit payments would be taxable pursuant to IRC section 105(a).
The authors of this revenue ruling note that it is equally applicable to short-term disability benefits.
Keep in mind that employee benefit advisors will need to alert employers that this approach will add .0765% (FICA) to the disability premium reported as compensation.
In addition, this approach can raise the LTD rate slightly, depending on the number of employees electing this option. Check with your LTD insurer first.
The employers’ and employees’ tax counsel should, of course, be consulted about any tax issue.