Guest Article

(From the June 14, 2004 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Revenue Ruling Offers Employers New Design Opportunity for Disability Plans

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 revenue ruling, which confirms a position the IRS took in a private letter ruling last year, is 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

The annual election approach outlined in this revenue ruling has the advantage of giving 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. As such, the revenue ruling may offer a low-cost way for employers to enhance the value of their disability benefits as perceived by their employees. However, this approach also raises communications and logistical issues employers should consider before adopting it. For example, the revenue ruling specifies 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. Furthermore, 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.

Legal Background

In general, employees do not pay federal income tax on the value of employer-provided accident or health insurance coverage, including short- and long-term disability insurance coverage. IRC section 106(a). But if employees do not include employer-paid disability insurance premiums in their gross incomes, they will pay taxes on any benefits they receive from the long-term disability insurance policy. IRC section 105(a).

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 three policy years, if known. IRC section 105(a) and Treas. Reg. Sec. 105-1(c). This is known as the "three-year look back rule."

The IRS in PLR 200312001 ruled that the three-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 aftertax 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.

Summary of Rev. Rul. 2004-55

The long-term disability plan at issue in Rev. Rul. 2004-55 is a fully-insured plan funded with a group insurance policy. The employer pays the annual premium for each eligible employee 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 all eligible employees to make an irrevocable election before the start of every plan year to have the employer's premium payments for that plan year included in their taxable incomes or not. Employees can make different elections for subsequent plan years. (The revenue ruling notes the employer also could use a default election procedure, which may be easier to administer.)

As in PLR 200312001, the revenue ruling concludes the plan is not a contributory plan and thus the three-year look back rule does not apply to this arrangement. So for purposes of 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). But 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).

Significantly, the revenue ruling notes the holding is equally applicable to short-term disability benefits.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Tom Brisendine 202.879.5365, Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879.5608, J. D. Lutz 202.879.5366, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5324, Tom Veal 312.946.2595, or Deborah Walker 202.879.4955. Copyright 2004, Deloitte.