Short-Term Disability Taxing, Withholding, and Reporting – Are You Doing It Right?
As the tax reporting season gears up each January, many companies discover flaws in their withholding and reporting practices. One benefit that employers commonly struggle to tax and report properly is short-term disability (STD). The tax issues are complicated in many cases, because the responsibility for the reporting can vary based on contractual terms between the employer and third party payer, which may be a third party administrator (TPA) or insurance carrier. The following is a general guide to the taxation and responsibility for withholding and reporting of STD payments.
Are STD benefits taxable?
It depends on whether the disability premiums were paid with employee contributions (taxable) or employer contributions (non-taxable). For these purposes, employee contributions paid with pre-tax dollars through a cafeteria plan under Section 125 of the Internal Revenue Code of 1986 (“Code”) are considered “employer” contributions. If employees pay STD premiums with after-tax dollars, then their STD benefit payments will not be taxable income. However, if the cost for the STD coverage is paid by the employer (or if the employee pays premiums on a pre-tax basis), then the STD payments will generally constitute income taxable to the employee.
If the employee and the employer both contribute towards the employee’s coverage under a group insurance policy, taxable STD benefits are determined by multiplying (i) the total benefit payments by (ii) the percentage of the policy’s cost that was contributed by the employer for the prior three policy years. If the STD policy has been in effect fewer than three years, you can use the cost for the policy years that the STD policy has been in effect or, if the policy has been in effect less than one year, a reasonable estimate of the cost for the first policy year.
Who is responsible for withholding payroll taxes on STD payments?
That depends on how the benefits are funded and administered.
- Self-Funded: Employers paying the total cost of the STD benefits on a self-insured basis are generally responsible for any payroll tax withholding responsibilities associated with the benefit payments, including social security and Medicare taxes (FICA), federal unemployment taxes (FUTA), and state unemployment taxes (SUTA). However, this responsibility may be contractually assumed by a TPA. STD benefits paid by the employer or TPA are also subject to mandatory federal income tax withholding. The employer or TPA withholding income tax from STD payments will generally determine the amount of tax to withhold based on the employee’s Form W-4 (the employee cannot choose how much federal income tax will be withheld by submitting a Form W-4S). If the TPA does not also pay the employee’s regular wages, it may choose to withhold federal income tax at a flat 22% rate, rather than at the wage withholding rate. Payroll taxes withheld from STD payments must be deposited under the same rules that apply to deposits of taxes on regular wage payments.
- Fully-Insured: If the STD coverage is fully-insured, the carrier generally retains liability for the employee and employer portions of FICA, FUTA, and SUTA, unless the employer agrees to assume this liability from the carrier. In order for the carrier to shift tax withholding and reporting responsibilities to the employer, the carrier is required to take the following specific actions delineated by the IRS:
- Withhold the employee part of social security and Medicare taxes from the benefit payments;
- Make timely deposits of the employee part of Social Security and Medicare taxes; and
- Send the employer a monthly notice regarding the payments on which employee taxes were withheld and deposited prior to its deadline for depositing the employee portion of FICA.
A carrier for fully-insured STD coverage is not required to withhold income tax; however, an employee may elect to have federal income tax withheld by submitting Form W-4S to the carrier.
How do you report STD benefits on a Form W-2?
STD benefit payments must be reported on the employee’s Form W-2, regardless of whether the benefits are taxable. Taxable STD benefits may either be combined with other wages on a single Form W-2, or employers may prepare a separate Form W-2 to report disability pay. Taxable income from STD payments is reported in Boxes 1, 3, and 5; federal income tax withheld from STD payments is reported in Box 2; Social Security tax withheld is reported in Box 4; and Medicare tax withheld is reported in Box 6. Non-taxable STD benefit payments are reported in Box 12 with Code “J” (Nontaxable sick pay).
The obligation to report STD benefits on Form W-2 generally falls on the employer if the STD coverage is self-insured, even if the coverage is administered by a third party (unless the TPA has expressly assumed responsibility for Form W-2 reporting). If the TPA has assumed reporting responsibility, it should report using its own name and EIN. For fully-insured coverage, however, the obligation to report STD benefit payments will generally fall on the carrier, which will issue employees Forms W-2 under its own name and EIN.
What should I do next?
Employers with STD plans (fully-insured and self-insured) should consult their plan advisor or ERISA counsel to confirm whether payments made to employees under its STD plan are taxable. Additionally, depending on how plan benefits are funded and administered, employers should seek legal guidance to ensure that it is meeting all required withholding and reporting obligations.
To make sure that STD plan operations are in compliance with IRS requirements (as described in the prior sections), employers should regularly review contracts with their STD carrier or TPA. For fully-insured coverage, it’s important to review any contracts with your carrier to confirm that the carrier retains all responsibilities for reporting and withholding obligations (or, if any responsibilities have been shifted back to the employer, the scope of those obligations). Similarly, employers with self-insured coverage should review contracts with TPAs and ensure that each party has an accurate understanding of their withholding and reporting responsibilities, and that proper procedures are in place to satisfy all of the employer’s obligations.
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