Section of Taxation Publications
  VOL. 60
NO. 3

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Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.

Controlling and Minimizing the Taxation of Disability Benefits
Vorris J. Blankenship*

* Partner, Davis Polk & Wardwell.


A taxpayer receiving disability benefits often relies on the payer of the benefits to determine the extent to which they are taxable, particularly when the benefits arise out of an employment relationship. Although the payer is usually experienced at applying the tax rules, the recipient of the benefits nevertheless has a much greater stake in an accurate determination. Consequently, the recipient is often well advised to ask his tax advisor to review the payer’s determinations and seek a revision when appropriate. For example, a tax advisor’s review may disclose that the payer computed the taxable percentage of disability benefits based on inappropriately determined classes of employees or improperly selected plan data.

Other situations may also call for the help of a tax advisor. For example, a tax advisor should be able to explain the different tax consequences of disability benefits and retirement benefits when a taxpayer has a choice between the two. The advisor may help find the most tax-advantageous way to allocate damages in the settlement of a disability dispute; or structure the settlement to eliminate tax on the income element in periodic payments. The advisor may help a taxpayer convert military retired pay to nontaxable military disability benefits or nontaxable veteran’s benefits. The advisor may document the validity, for tax purposes, of a retroactive redetermination of nontaxable workers’ compensation.

In other contexts, a tax advisor may help an employer structure a disability plan that is most advantageous to both the employer and employees. For example, an employer may be able to provide employees with a choice between disability plans with different tax and economic consequences—with little or no tax consequence to the employer. This Article discusses these and other tax planning considerations.

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. The latter nontaxable category includes disability payments (a) under workers’ compensation acts, (b) for disfigurement or loss of limbs or bodily function, (c) for injuries caused by terrorists or the military, (d) for combat related injuries, and (e) under judgments or settlements for wrongful injury or sickness.

This Article refers to the latter nontaxable category of benefits as “exempt disability benefits” and uses the term “sourced disability benefits” to refer to disability benefits that are taxable or nontaxable depending on their funding source. For this purpose, “disability benefits” means a payment or payments dependent on short-term or long-term physical or mental disability, most usually intended to replace some or all of the lost wages, salary, or other compensation of the disabled individual. The term does not include any payment that reimburses medical expenses, as defined in section 213(d), or any payment under a long-term care insurance contract, as defined in section 7702B(b). Nor, for purposes of this Article, does this term include social security disability benefits, which, as discussed infra, are generally taxable in the same way as regular social security retirement benefits.


Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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