Although death and taxes are both viewed as inevitabilities, when it comes to disability insurance benefits, taxes may be avoidable.
According to Revenue Ruling 2004-55 (June 28, 2004), long-term disability insurance premiums paid on an after-tax basis result in a non-taxable benefit. Hence, many employers structure their group long-term disability benefit plans in that manner to provide a nontaxable benefit to their employees in the event they become disabled. However, although disability insurance benefits may not be taxable, Social Security disability benefits are.
So if a worker is promised a tax-free disability insurance benefit, and that employee later becomes simultaneously eligible to receive both long-term disability payments and Social Security disability insurance payments, which reduce the LTD payments, does the insurer get to offset the gross amount of SSDI or the after-tax net amount?
That question was recently answered in Troiano v. Aetna Life Insurance Co., 2015 WL 5775160 (D.R.I. Sept. 30, 2015). Debra Troiano was the recipient of tax-free disability benefits from Aetna Life Insurance Co. based on her participation in a group disability benefit program sponsored by her employer, General Dynamics Corp. However, as is the case with all group LTD plans, Troiano’s benefits were reduced by the SSDI benefits she also received.
Aetna insisted on offsetting the gross amount of the SSDI payments, but Troiano protested. She claimed that her LTD benefits were nontaxable, and since her Social Security benefits were taxed, she argued that the promise of a nontaxable LTD benefit payable at 60 percent of her pre-disability salary was diminished.
Unless the net after-tax Social Security benefit was offset, Troiano maintained that she would be receiving total disability payments that were less than 60 percent of her salary.
Aetna responded by advising Troiano: “It is industry standard to offset the Social Security Disability Income (SSDI) gross amount and not the net amount. To adjust the SSDI offset, according to net amount, would involve taxes and we do not get involved in taxation.”
Aetna did, however, reduce Troiano’s SSDI setoff by the attorney fees and costs incurred in obtaining those benefits and advised her that cost-of-living increases added to her Social Security benefits would not be offset.
Troiano attempted to appeal Aetna’s determination; however, Aetna disregarded her submission. Troiano then brought suit against Aetna, which was before the court on the parties’ cross-motions for summary judgment.
The court granted deference to Aetna despite citing R.I. Gen. Laws Section 27-4-28, banning discretionary clauses in insurance policies. Although that statute is a state law regulating insurance and would be saved from pre-emption under the Employee Retirement Income Security Act, 29 U.S.C. Section 1144(b)(2)(A), the court ignored the ERISA savings clause and declared the law pre-empted.
The court also rejected Troiano’s argument that Aetna’s failure to act in response to the pre-litigation appeal resulted in a forfeiture of discretionary authority.
The court ruled that no language in the plan supported the plaintiff’s claim that the offset of Social Security benefits would be based on the net benefits after taxes and that illustrations in a summary plan description provided to Troiano compelled a conclusion that the gross benefit is offset.
The court disagreed that a gross SSDI offset reduced the value of the plaintiff’s LTD benefits by “nullifying the tax advantages” of the plaintiff’s payment of premiums for coverage with after-tax dollars.
Furthermore, the court pointed out that the net benefit Troiano continued to receive from Aetna remained nontaxable. The court maintained that Troiano was seeking “an assumption of her SSDI tax liabilities by Aetna” unsupported by the policy’s language.
Ultimately, the court concluded that requiring Aetna to reduce Troiano’s benefits by the net after-tax Social Security amount would be “unreasonably burdensome and preclude the orderly and effective administration of the plan.”
The court’s ruling appears unjustified. Troiano contracted to receive a nontaxable disability benefit equal to 60 percent of her pre-disability salary in the event she suffered a disabling injury or illness. She is not receiving the full financial protection she contractually bargained for.
While the contract allowed Aetna to reduce her LTD benefits by the amount of her SSDI benefits, the combination of both the net remaining long-term disability benefit plus the Social Security should still be equal to 60 percent of her salary net of taxes. There is no unreasonable burden or interference with the orderly and effective administration of the plan for Aetna to request a copy of the claimant’s tax return to perform a simple calculation.
The decision mentions that Aetna was willing to credit Troiano’s fees and expenses in obtaining the Social Security benefits even though the plan is silent on that issue. But Aetna has to do so- it’s a matter of equity, which incorporates the common-fund doctrine into the plan as an implied plan term or an equitable reformation of the plan terms. Since Aetna benefits from the offset, the common-fund doctrine equitably mandates that it share the expense incurred in obtaining the SSDI award.
Calculating and crediting the Social Security fees and expenses is no less burdensome than calculating an offset of the after-tax Social Security benefit, yet Aetna routinely manages to perform such calculations.
And even though Social Security usually pays cost-of-living increases, Aetna advised the court that those increases are not offset- obviously to prevent erosion of the promised benefit since the LTD benefits are not increased on account of inflation.
The Supreme Court has repeatedly pointed out that the ERISA law is based on the law of equity. In CIGNA Corp. v. Amara, 563 U.S. 421 (2011), the court pronounced that the doctrine of equitable reformation permits an aggrieved plan participant to seek equitable reformation of a benefit plan in order for the plan to provide the promised benefits.
Here, too, that doctrine should be applied to require that Aetna be permitted to offset only the after-tax net Social Security benefit. Otherwise, claimants such as Debra Troiano are denied the full amount of promised benefits.
This article was initially published in the Chicago Daily Law Bulletin.