Receipt of disability benefits raises several tax issues. The resolution of such matters concerning disability benefits is often unclear and can sometimes be highly complex. For that reason, this blog is not intended to be an exhaustive discussion of the potential issues. Moreover, the blog provides no more than a general overview of the problems and is not intended to offer tax advice. Readers are strongly encouraged to consult their tax advisors for a definitive opinion on the tax treatment of their benefits and should not rely on any points raised in this article.
Table of Contents
- Are Disability Benefits Taxable?
- If I Had to Hire an Attorney to Collect Taxable Disability Insurance Benefits, Can I Deduct Attorneys’ Fees?
- Are Lump Sum Settlements of Disability Benefits Subject to Taxes?
- If Part or All of an Overpayment Is Forgiven in a Settlement, Is the Amount That Is Forgiven Taxable?
- If My Disability Benefits Are Taxable and I Receive a Settlement of My Claim, Is There an Advantage to Receipt of a Structured Settlement?
Are Disability Benefits Taxable?
The taxability of disability benefits depends on their source and how premiums are paid. For example, Social Security disability benefits are taxable if the recipient (and spouse if the benefit recipient files taxes jointly) have earnings in addition to Social Security payments. For individuals with more than $34,000 in income, 85% of benefit payments are taxable. For joint filers, combined earnings over $44,000 are subject to 85% of the benefit to taxes.
Individual disability income insurance payments are generally not taxable so long as the individual receiving such payments paid the premiums with after-tax dollars. Group benefits are usually taxable, however, in accordance with the amount of the premiums for the insurance coverage that the employer pays. A FAQ issued by the Internal Revenue Service explains:
- If both you and your employer have paid the premiums for the plan, only the amount you receive for your disability due to your employer’s payments is reported as income.
- If you pay the entire cost of a health or accident insurance plan, don’t include any amounts you receive for your disability as income on your tax return.
- Suppose you pay the premiums of a health or accident insurance plan through a cafeteria plan, and you didn’t include the premium amount as taxable income to you. In that case, the premiums are considered paid by your employer, and the disability benefits are fully taxable.
One problematic issue is whether claimants who must reimburse their long-term disability insurance company after receipt of Social Security disability benefits should receive a credit for the taxes owed on the Social Security benefits. Disability insurers will only credit attorney fee payments incurred to collect Social Security and usually not credit taxes. To date, litigation on this issue has been unsuccessful.
If I Had to Hire an Attorney to Collect Taxable Disability Insurance Benefits, Can I Deduct Attorneys’ Fees?
The fees would be likely deductible if a hired attorney makes a claim or files a lawsuit to recover taxable disability benefits. But, this is a question on which many tax professionals disagree due to the Tax Cuts and Jobs Act of 2017, which limited the deduction of attorneys’ fees for non-business-related litigation. However, according to provisions contained in Section 62 of the Internal Revenue Code, which was not impacted by the 2017 law, costs and attorneys’ fees incurred concerning claims for unlawful discrimination are excluded from the taxpayer’s gross income. The statute defines unlawful discrimination to include claims involving wages, compensation, or benefits. Thus, only the net proceeds paid to the claimant should be subject to taxation.
Are Lump Sum Settlements of Disability Benefits Subject to Taxes?
The taxability of a lump sum payment of disability benefits – either as the result of a lawsuit settlement or an agreement with the insurance company to accept a reduced payment now in place of payments over future years – is the same as the taxability of monthly payments. Thus, if monthly payments are tax-free, a lump sum settlement should be as well.
However, one potentially problematic issue is if the insurance company requests that the settlement be confidential. The Internal Revenue Service has taken the position in personal injury settlements, generally paid on a tax-free basis. While the payment itself may not be taxable, any portion of the payment to secure the confidentiality of the settlement payment may be viewed as taxable income. The problem may be avoided with careful drafting of a settlement agreement.
If Part or All of an Overpayment Is Forgiven in a Settlement, Is the Amount That Is Forgiven Taxable?
In court cases involving long-term disability benefit payments that have been terminated after being paid for some time, the insurance company may assert a counterclaim alleging that the claimant has been overpaid as the result of an award of Social Security disability, workers’ compensation, or some other payment that reduces the amount of disability benefits the claimant should have received. When such cases are settled, there is usually a mutual release that forgives the overpayment. The forgiveness of debt potentially creates tax liability; however, the tax obligation can generally be avoided with appropriate language inserted into the settlement agreement.
If My Disability Benefits Are Taxable and I Receive a Settlement of My Claim, Is There an Advantage to Receipt of a Structured Settlement?
Structured settlements are a popular way to resolve personal injury claims to preserve the settlement funds and avoid imprudent expenditures. However, personal injury payments differ from disability insurance benefits since damages received on bodily injuries are not included in gross income taxed by the IRS. That results in far greater flexibility in setting up a structured settlement than would be the case with a taxable lump sum settlement of disability benefits. Even if the lump sum is invested in an annuity that pays out only a percentage of the total each year, the disability benefit recipient would likely be deemed to have constructive receipt of the entire sum used to purchase the annuity.
There may be means of avoiding constructive receipt by utilizing an offshore insurance company and making that entity the owner of the annuity and the claimant the beneficiary of each payment as it is issued. However, that type of arrangement raises a risk that the “owner” of the annuity may become insolvent. If that occurs, any remaining payments would be lost since there is no protection as would exist if a domestic insurance company failed.
Taxes are complicated, and even savvy people with significant business experience can make serious tax mistakes without the assistance of a tax professional. The insurance companies that pay disability benefits make no representations about tax liability or take responsibility for tax issues that arise. Further, tax law is an entirely different field despite an attorney’s experience and expertise in dealing with disability benefits issues. The attorney may not be willing or able to provide tax advice.
Before disability occurs, though, to the extent someone who has disability insurance has the option through their employer or their business entity of setting up their disability program on a taxable or non-taxable basis, it would be preferable to elect benefits that are not subject to taxation. Making such an election is that if a dispute of the benefits arises, claims can be more easily settled if there is no substantial tax liability.