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IRS
Ruling on
Premium Options

Does your company pay disability insurance premiums for employees? A private letter ruling from the IRS provides a blueprint for your firm to shift the tax treatment on this benefit.

We'll explain but first, here's a little background on the tax treatment of disability insurance:

In the normal course of events, an employee doesn't owe tax on disability insurance premiums paid by an employer. However, if and when benefits are paid out under a disability policy, the proceeds are fully taxable if the company paid the premiums. In other words, a family may have to pay an extra tax bill at the worst possible time.

Conversely, an employee doesn't have to pay tax on disability insurance benefits if the cost of the premiums is paid by the employee with after-tax dollars or included in the employee's taxable income.

Here's where the private letter ruling from the IRS comes in. The IRS gave approval to a company in the ruling, which amended a standard disability insurance plan and gave employees two choices:

They can accept the status quo of having the company pay their disability insurance premiums as a tax-free fringe benefit. However, this means actual benefit payments received under the policy will be fully taxable.

They can choose to have the disability insurance premium amounts taxed as compensation by agreeing to pay the premiums with after-tax dollars withheld from their paychecks. The choice is irrevocable and must be made at the beginning of the year. (IRS LR 200146011) If this option is chosen, all the actual benefit payments received under the policy will be completely tax-free. In most cases, choosing this option is the best way to go.

This option may be particularly beneficial to older employees who face a higher risk of suffering a severe disability. Ask your tax adviser for more information about the taxability of disability insurance benefits.