What is it?

In general

The inability to work due to physical or mental incapacity is a major cause of concern for many employees. Providing your employees with the security of a sick-leave plan or disability insurance can help alleviate some of this concern. A sick leave plan can reimburse your employees for lost wages as a result of a sickness or accident that lasts for a short period of time (usually no longer than six months). Disability insurance provides your employees with benefits during the period when he or she has a disability and is unable to work. The type of disability insurance that you provide to your employees will depend on the types of disabilities you would like to cover under your disability insurance plan. There are three types of disability insurance plans: short-term disability, long-term disability, and permanent disability.

Tip: There is usually a waiting period before employees can begin receiving their disability income insurance benefits.

Internal Revenue Service (IRS) tax treatment of disability insurance plans

If you provide your employees with disability insurance, you may be eligible for tax deductions. Contributions that you make to a disability insurance plan may be deductible as ordinary and necessary business expenses as long as you self-insure or fund the plan with insurance. Whether or not you can exclude the amount that your employee receives under the plan from your employees’ gross income depends on who pays the premium. If your employee pays the total premium using after-tax income, then his or her benefits will be tax free. Conversely, if you pay the total premium and do not include the cost of coverage in the employee’s gross income, then the employee will be taxed on the benefits. If you pay part of the insurance premium and your employee pays the rest, then your employee’s tax liability will be split as well. Any part of the benefit that your employee receives that is attributable to your share of the premium is taxable; any part of the benefit attributable to your employee’s share of the premium is tax free.

Example(s): Bob was covered by a group disability insurance plan at work. His employer paid 60 percent of the monthly premium, and Bob paid 40 percent using after-tax dollars. When he became disabled, Bob received a $1,000 benefit monthly for six months ($6,000). When he filed his income taxes, he only had to pay taxes on $3,600 (60 percent of $6,000), the part attributable to his employer’s contribution.

Sick-leave plans

Under a sick-leave plan, you either wholly or partially reimburse your employees for lost wages resulting from a sickness or accident that lasts for a short period of time (usually no longer than six months). Sick-leave plans usually provide benefits for a specific number of days each year. You can either allow your employees to accrue sick days on a monthly basis, or you can allocate your employees with a certain number of sick days each year. You do not have to purchase insurance to set up a sick-leave plan. Instead, you administer and fund the plan yourself. If you choose to implement a sick-leave plan, sick leave may be includable in your employee’s gross income as wages. However, you may be able to deduct all or part of the cost you incur by providing your employees with a sick-leave plan.

Make sure the sick-leave plan that you offer to your employees is in writing.

Under a sick-leave plan, you can allow your employees to carry over any sick days that they do not use to the following plan year.

Ken works for a factory that allows its employees to earn one day of paid sick leave for each month of full-time employment. After a year of full-time employment with the factory, Ken has used only 3 of his 12 earned sick days. The factory allows him to carry over the 9 remaining sick days to the following plan year.

Short-term disability

Short-term disability often bridges the gap between sick pay and long-term disability coverage by providing benefits that cover temporary disabilities for a limited time period (typically less than one year). The length of disability coverage under a short-term disability plan can last anywhere from a few months to one year. Under a short-term disability plan, an employee is considered to have a disability when the employee is unable to perform his or her regular duties.

Tip: If you provide your employees with short-term disability insurance, you must also provide your female employees with benefits during pregnancy and childbirth.

Tip: Insurance companies will differ in their interpretation of the beginning of a new period of disability. Some companies require that your employee return to work for one day, while others require a few months of continuous active employment.

Examples: Ken works at a factory. The factory’s short-term disability plan provides that employees can receive three weeks of benefits for each period of disability. Ken was out of work for three weeks due to a back injury he received while on the job. Three days after returning to work, he reinjures his back. Thankfully, the disability insurance company interprets his new period of disability as beginning the day after he returned to work.

Long-term disability

Long-term disability insurance usually provides benefits to employees who are disabled as a result of sickness or accident, and who are unable to work for a lengthy time period, usually longer than six months. The benefit an employee receives from long-term disability insurance is usually 50 percent to 70 percent of their predisability pay. Typically, the employee can receive long-term disability benefits up until he or she reaches age 65. The definition of disability will vary from policy to policy.

Tip: Since long-term disability plans (that are not self-insured plans) do not have to follow IRS nondiscrimination rules, you can reduce a plan’s overall costs by offering it to only a select group of employees.

Tip: Long-term disability benefits usually do not kick in until your employee uses up all of his or her short-term disability benefits.

Example(s): Ken, who works at the local factory, injured his back while playing golf. Ken was entitled to one year of short-term disability benefits. Almost a year after he first injured his back, Ken was still out of work, and his short-term benefits were about to run out. Luckily, the factory offered its employees additional long-term disability benefits that will take effect once Ken’s short-term benefits run out.

Permanent disability

If your employee becomes permanently disabled before reaching age 60, he or she may be able to receive permanent disability benefits through provisions that are contained in an employer-provided group life insurance policy. This is not a cash benefit but rather a bill that does not need to be paid. A permanent disability is a disability that prevents you from being able to work at any job. A typical life insurance provision that is used for permanent disabilities is a waiver of premium, which continues coverage of an employee who becomes disabled. The coverage lasts until the employee’s death and is without the payment of any premium.