Guide to Taxation of Employee Disability Benefits

The taxable part of disability benefits is based on the source of the premiums.

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The Internal Revenue Service classifies all forms of disability benefits as sick pay. This includes funds paid by an employer, insurance company or other third party. That includes statutory disability insurance, long-term disability payments and short-term disability payments. The tax treatment of your disability benefits depends on the source of the premiums for your company's disability insurance policy.

Post-Tax Premiums

If you pay part of your disability insurance premiums with after-tax money, part of your disability benefits may be taxable. Determine the percentage of insurance premium covered by your employer and multiply this by the amount of the disability payout to find the taxable part. If the company has provided insurance for multiple years, you can use the three year average of the employer's percentage to calculate your taxable benefits. Unlike your medical insurance premiums, disability insurance premiums are not deductible as a medical expense.

Cafeteria Plans

Section 125, or "cafeteria," plans let you pay your disability insurance premiums with pretax funds. If you only pay part of the premium and your employer covers the rest, 100 percent of the benefits are taxable to you. If you suffer a total or partial disability, you may be entitled to a tax credit against your benefits at the end of the year.

Benefits for Owners

Sole proprietors pay their own disability insurance premiums, and the cost of insurance is included in gross income, so any disability benefit payouts are not taxable to the owner. Owners of S corporations, limited liability companies and partnerships are not considered employees when determining whether disability benefits are taxable. In this case, the cost of disability insurance is included in gross income, so the benefit payments are not taxable to the owner. Owners of C corporations are treated as employees, and benefits are taxable to the employee according to the proportion of the insurance premium the corporation pays.

Tax Reporting

The employer must report sick pay to the IRS on Form 941, including disability benefits and taxes withheld. All applicable tax withholding must be paid to the IRS and state tax authorities. The employer's benefits administration company may be able to provide reporting and tax-filing services. As an employee, you will receive your individual information on Form W-2 before Jan. 31 of the year after payment.