Guest Article

(From the April 7, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

IRS Private Letter Ruling Provides Overview of Tax Rules Relating to Long-Term Disability Plans

Should employees allow themselves to be taxed on employer-paid group long-term disability insurance premiums? (Should employers give them a choice?) There is no "right" answer for every situation, but a recent IRS private letter ruling (PLR) highlights one approach employers may use to give employees substantial flexibility to decide what is best for them-- and to change that decision on an annual basis. PLR 200312001 (November 13, 2002).

Legal Background

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

Employees can avoid taxes on long-term disability insurance benefits by paying the premiums themselves, 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). Under that scenario, employees can avoid paying income taxes on part-- but not all-- of their long-term disability benefits. IRC section 105(a) and Treas. Reg. Sec. 105-1(c).

Issue for Employers

Most employees probably would prefer to not pay taxes on employer-paid long-term disability insurance premiums. But those that end up receiving taxable disability benefits may have a different perspective.

Employers that provide long-term disability coverage often allow employees to choose between including and not including premiums in their taxable incomes, but some only let them choose once. Under these arrangements, employers must be careful to explain the trade-offs to employees before they make their elections. Other employers avoid this communication problem-- and the potential fiduciary issues that come with it-- by not giving employees a choice.

The arrangement the IRS analyzed in this PLR offers a third alternative employers may want to consider. Clearly, this annual election approach has the advantage of giving employees the flexibility to change their minds about paying taxes on employer premium payments as they become more (or less) concerned about disability. But this approach also creates communications and logistical challenges employers should consider before adopting it.

PLR Summary

The long-term disability plan at issue in PLR 200312001 is a fully-insured plan funded with a group insurance policy. The employer pays the annual premium for each eligible employee. But before the start of every plan year, all eligible employees must elect in writing either to include the employer's premium payments in their taxable incomes or not. Employees may not change their elections once the plan year begins, but they can make different elections for subsequent plan years. The employer asked for IRS guidance on how the plan's long-term disability benefit payments will be taxed.

Significantly, IRS noted the plan is not a contributory plan because it is financed either solely by the employer or solely by the employee. Even though it is possible under the plan for the employer to finance coverage one year and the employee the next, it is not possible for both the employer and employee to share the burden of financing coverage in any single year. The distinction between contributory and noncontributory plans is important because, as noted, employees participating in contributory plans must pay tax on part of any long-term disability benefits they receive. [See Treas. Reg. Sec. 1.105-1(d) and (e) for guidance on determining the taxable portion of benefits paid from a contributory plan.]

IRS then concluded 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 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).

The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte.