How Can a Claimant Exclude Disability Insurance Benefits from Federal Taxes?

As disability lawyers we do not provide any tax advice. We are routinely asked about the tax implications of disability insurance benefits. In an effort to provide some answers in this area we reached out to Gary Kaplan, a certified public accountant.

Issue

What actions can a claimant take in order to exclude Disability Insurance Benefits from personal income tax?

Hypothetical Fact Pattern

A surgeon, Dr. Smith, has been diagnosed with Multiple Sclerosis, which is a chronic disease that becomes increasingly debilitating over time.  Dr. Smith anticipates that he will not be able to work in his current profession within 4 years. Dr. Smith has disability insurance through a plan provided by his employer, Surgery Specialists. The medical practice is a separate legal business entity, taxed as an S Corporation, and Dr. Smith is the 100% owner and an employee. Up until now, Surgery Specialists has paid and deducted the entire disability premium as a business expense. Surgery Specialists does not include the cost of coverage as W-2 gross income to Dr. Smith; thus his disability policy is being paid for as a personal tax-free benefit.

Tax Law And Analysis

Under Section 1.105-1(a)of the Internal Revenue Code, if an employee does not include any employer-paid disability insurance premiums in gross income, they will have to pay personal income tax on all future benefits received from the disability policy. Conversely, if the employee pays personal income tax on the entire employer-provided disability premium, none of the disability benefits will be taxable to the recipient.

Under Section 1.105-1(d)(2), provides for  what is known as the “three year look back rule”. If the premiums are paid by employer and employee, the individual will only pay income tax on benefits on the ratio of:

Net premiums contributed by the employer for the last three policy years prior to the calendar year in which the disability occurs, divided by the total net premiums paid by both the employer and employee for the same period.

As covered by Revenue Ruling 2004-55, an employer plan can be amended allowing employees to make an irrevocable election to pay for the cost of disability coverage with after-tax dollars (i.e. employee pays income tax on the value of the premiums). The employee’s election is irrevocable for the entire plan year, and can be changed annually before the beginning of each succeeding plan year.

Conclusion

Dr. Smith has the unique situation of knowing his impending disability over three years in advance. He has adequate time to amend his business/employer disability plan, allowing him to make an employee election to pay the disability premiums with personal, after-tax dollars. He would be able to take advantage of the three year look back rule and receive future stream of disability payments tax-free. The long-term tax savings should far outweigh the cost of making after-tax premium payments.

This case study does not consider the tax treatment of Social Security disability payments, or other issues that may affect your particular situation. Tax planning for disability and other complex issues should be made with experienced professionals.

If you have specific questions about tax issues related to disability insurance, Gary Kaplan can be reached at 866-643-3560 or by visiting his website at gkaplancpa.com.