Tax-free disability benefits: new IRS ruling allows favorable treatment.

Rev. Rul. 2004-55, IRB 2004-26, June 28, 2004, considered the following issue: Under an "Amended Plan" (described below), are long-term disability benefits received by an employee, who becomes disabled, excludable from the employee's gross income under Sec. 104(a)(3)?

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Facts

An employer provides long-term disability benefits pursuant to a written plan to its eligible employees through a group insurance policy with a third-party insurance carrier. Under the plan's terms, the employer pays the entire premium for this coverage and excludes the coverage's cost from the employee's gross income. Thus, these premiums are paid on a pre-tax basis since they are not reported on the employee's Form W-2.

The employer amends the plan (the Amended Plan) to provide that the employer will continue to pay for this coverage on a pre-tax basis for eligible employees. However, each eligible employee may also irrevocably elect to have the employer pay for this coverage on an after-tax basis (i.e., elect to be taxed currently on these employer-paid premiums).

An employee's election applies to the entire cost of the coverage that the employer pays to the insurance carrier; an employer may not elect after-tax treatment for only some of the premiums.

If an employee elects after-tax treatment, the employer allocates the appropriate portion of the group premium to that employee and includes that amount in the employee's gross income for the year in which the payments are made (i.e., the premiums are reported on the employee's Form W-2 for that year).

Under the Amended Plan, the employee's "after-tax" election is irrevocable once the plan year begins and must be made before the beginning of the plan year in which the election becomes effective. The employee can make a new irrevocable election for each plan year before that year begins.

Instead of a new election for each plan year, the employer may provide that an employee's prior election continues for succeeding years unless affirmatively changed before a new plan year begins. The employer also may provide that long-term disability premiums will automatically be included in the employee's gross income unless the employee affirmatively elects otherwise before a new plan year begins.

Relevant Statutes and Regulations

Sec. 104(a)(3) generally states that gross income excludes amounts received through accident or health insurance (or through an arrangement having the effect of such insurance) for personal injuries or sickness other than amounts received by an employee to the extent they are:

* Attributable to employer contributions that were not includible in the employee's gross income; or

* Paid by the employer.

Under Regs. Sec. 1.105-1(b), all amounts received by employees through an accident or health plan that is solely employer-financed are subject to Sec. 105(a)--which generally provides that such amounts (received for personal injuries or sickness) must be included in gross income to the extent they are:

* Attributable to employer contributions that were not includible in the employee's gross income; or

* Paid by the employer.

IRS Analysis

When a plan providing long-term disability benefits is amended, as described above, the Amended Plan is a new plan in computing the employer's and employee's contributions. With respect to each employee, the Amended Plan is financed either solely by the employer or solely by the employee. At no time is coverage under the Amended Plan financed by both employer and employee contributions.

Therefore, the Amended Plan is not a contributory plan and, accordingly, there is no need to determine the portion of amounts received that is attributable to employer contributions (pursuant to regulations prescribed under Sec. 105).

IRS Conclusions

Under this Amended Plan, long-term disability benefits received by an employee who has irrevocably elected, before the beginning of the plan year, to have the coverage paid by the employer on an after-tax basis for the plan year, in which the employee becomes disabled, are attributable solely to after-tax employee contributions. Thus, they are excludable from the employee's gross income under Sec. 104(a)(3).

Under the Amended Plan, long-term disability benefits received by an employee whose coverage is paid by the employer on a pre-tax basis for the plan year, in which the employee becomes disabled, are attributable solely to pretax employer contributions. Thus, they are includible in the employee's gross income under Sec. 105(a).

These conclusions are equally applicable to short-term disability benefits.

Tax Planning Considerations

An employee whose health is declining should consider making the election, if available, to pay for disability coverage on an after-tax basis. Since the possibility of disability increases with age, older employees--even though healthy--also should consider making this election.

If the election is made and disability occurs, the benefits received will be taxfree even if premiums were excluded from income in previous years.

Of course, if an employee elects to pay for disability coverage on an after-tax basis, the coverage's cost will be subject to employee and employer payroll taxes--in addition to employee income tax.

By Stuart R. Josephs, CPA 

Stuart R. Josephs, CPA, has a San Diegobased Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].

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