Controlling and Minimizing the Taxation of Disability Benefits

By Vorris J. Blankenship

The law governing taxation of disability benefits is extensive. Generally, though, disability benefits fall into two categories for tax purposes: (1) those benefits taxable or nontaxable depending on their source of funding and (2) those nontaxable regardless of their source of funding.

Sourced disability benefits. Sourced disability benefits are includable in gross income to the extent their source of funding is employer contributions previously excluded from employee gross income. If such excludable employer contributions are the source of all the funding, the disability benefits are entirely includable. If the employer makes no such excludable employer contributions, the disability benefits are entirely nontaxable. If the excludable employer contributions provide only part of the funding, only a corresponding portion of the benefits is includable.

The method for determining the includable portion of sourced disability benefits only partially funded by an employer differs depending on whether the plan consists of an individual disability insurance policy, a group disability insurance policy, or uninsured coverage. The percentage of disability payments includable in gross income under an individual insurance policy is the same as the
percentage of total premiums contributed by the employer. The percentage of disability payments includable under a group insurance policy or a funded uninsured plan is generally the same as the percentage of the total contributions made by the employer during a specified period of years. There is, however, some uncertainty regarding identification of the policy years used to compute the includable percentage of payments under an individual or group insurance policy.

If employee or employer contributions to a plan differ for different classes of employees, a taxpayer or employer must try to determine the employer contribution percentage separately for each class. Those employees providing a higher proportion of total contributions for their benefits will have a substantial stake in the separation of the classes.

If a plan provides both disability benefits and other types of benefits, the taxpayer or employer must allocate employer and employee contributions among the various benefit categories. A plan providing retirement benefits must allocate contributions in accordance with the terms of the plan or, in the absence of such terms, must cover the cost of disability benefits with employer contributions and related earnings before applying employee contributions. Other plans must allocate contributions in accordance with the plan’s actual application of the contributions, or if that is not determinable, must allocate the contributions proportionately.

Some plans allow an employee to make an election to bear the full cost of disability insurance coverage on an after-tax basis, thus making any ultimate disability payments non-taxable. Although there does not appear to be any express authority allowing a similar election for a funded uninsured plan, the rationale for allowing the election for an insured plan appears also to provide some support for an election for an uninsured plan. A taxpayer will generally find it advantageous to make an available election if the amount of the disability benefit remains unchanged after the election.

Disability benefits may become taxable as retirement benefits when a disabled taxpayer reaches retirement age. From a planning standpoint, the conversion might be beneficial if a larger portion of retirement benefits is nontaxable. However, the conversion should not be available, or required, to the extent the disability benefits exceed the retirement benefits the taxpayer would otherwise have been eligible to receive, or if the taxpayer would not otherwise qualify for retirement benefits.

Exempt disability benefits. Tax-exempt disability benefits include disability payments (1) under workers’ compensation acts or similar statutes; (2) for disfigurement or loss of limbs or bodily function; (3) for injuries caused by terrorists or the military; (4) for combat-related injuries; and (5) under judgments or settlements for physical injury or sickness.

Workers’ compensation benefits for personal injuries or sickness occurring in the course of employment are generally excludable from gross income. The benefits are excludable even if the taxpayer is able to work in some other occupation or if the benefits are received by survivors of the taxpayer. However, the exclusion does not apply to the extent a retiree’s benefits depend on age, length of service, or prior contributions.

Amounts paid under a statute in the nature of a workers’ compensation act, such as an occupational disability statute, may qualify as workers’ compensation. However, the statute must specifically limit payments to compensation for injuries or sickness incurred in the course of employment. A statute may be an occupational disability statute even though it incorporates a rebuttable presumption that a specific type of injury or sickness occurred in the course of employment. An irrebuttable presumption is more problematical because it could potentially allow employees to receive benefits for non-occupational injuries or sickness.

If a taxpayer’s disability occurs after reaching retirement age, the taxpayer may be able to choose between workers’ compensation benefits and regular retirement benefits. On the other hand, excludable workers’ compensation benefits received under an occupational disability statute may automatically convert to regular retirement benefits when the taxpayer reaches retirement age.

The cases and rulings have not definitively prescribed the tax treatment of benefits that fail to qualify as workers’ compensation though putatively paid under an occupational disability statute. Generally, though, it seems appropriate to treat the nonqualifying benefits as regular retirement benefits if it is apparent the benefits are intended as a substitute for retirement benefits. On the other hand, nonqualifying benefits should be treated as sourced disability benefits if the taxpayer does not qualify for regular retirement benefits or to the extent the disability benefits are in excess of regular retirement benefits.

Certain disability payments for disfigurement or loss of a member or function of the body are excluded from gross income. The payments must be for a permanent injury. The amount of the payments must be based on the nature of the injury and must vary with the type of injury. The amount of the payments must not be based on the length of the period the taxpayer is absent from work or on the taxpayer’s lost wages or diminished earnings capacity.

Some disability benefits paid by the military and certain other government agencies are excludable from gross income if paid for combat-related injuries or sickness. However, the injuries or sickness need not be combat related if the taxpayer was entitled to receive some of the disability payments on or before September 25, 1975, or if on that date the taxpayer was a member of the military or certain other government agencies. All disability benefits paid by the Department of Veterans Affairs are excludable from gross income. U.S. military retired pay is excludable to the extent the taxpayer could successfully apply for and receive the payments instead from the VA.

Disability benefits for physical injuries or sickness caused by the tortious acts of others are generally excludable from gross income if paid as damages in a lawsuit or settlement. However, a taxpayer generally may not exclude punitive damages or some types of damages paid for emotional distress. Structured settlements facilitate the exclusion from gross income of periodic disability payments resulting from an actual or threatened lawsuit or a workers’ compensation claim. 

For More Information About the Section of Taxation

- This article is an abridged and edited version of one that originally appeared on page 725 of The Tax Lawyer, Spring 2007 (60:3).

- For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.

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- Periodicals: NewsQuarterly, quarterly newsletter; The Tax Lawyer, quarterly journal; The Practical Tax Lawyer (published by ALI-ABA in cooperation with the Section), subscription available to Section members at a significant discount.

- Books and Other Recent Publications: Effectively Representing Your Client Before the “New” IRS: A Practical Manual for the Tax Practitioner with Sample Correspondence and Forms; Sales and Use Tax Deskbook; The State and Local Tax Lawyer; Property Tax Deskbook; A Comprehensive Analysis of Current Consumption Tax Proposals; State and Local Taxation of Banks and Other Financial Institutions; Value Added Tax: A Model Statute and Commentary.

Vorris J. Blankenship is an attorney and CPA in California. He may be reached at .

Copyright 2008

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