Legislative & Regulatory Information

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1 U.S. Business Legislative, Privacy & Projects Jurisdiction Effective Date Author Release Date File No. UFS Topic Citation: Reference: Federal IMMEDIATE Louis Enahoro 6/28/12 LI-444 Disability 26 USC 3402(o), 6051; 26 CFR , IRS Rev. Rule Supersedes LI-430 RATIO OF EMPLOYER-EMPLOYEE CONTRIBUTIONS NEEDED FOR STD/LTD PLANS This release: Executive Summary briefly restates federal tax law requirements for withholding and reporting of disability income; is a reminder that an annual allocation of the portion of disability benefits attributable to employer and to employee contributions must be made; and provides a worksheet for employers with MetLife disability income plans to complete. This information must be returned to MetLife prior to the initial implementation and each year BEFORE November 1. Background In this release, the term disability income benefits refers to short term disability (STD), also known as accident and sickness benefits (A&S), long term disability benefits (LTD), and unified disability benefits (STD/LTD). Employer-paid disability income benefits are generally subject to federal income tax (FIT), state and local income taxes, Social Security and Medicare (FICA) taxes, federal unemployment tax (FUTA), and state unemployment taxes (SUTA); the portion paid for by employees with after-tax contributions is not. Therefore, it is very important to allocate the portion of benefits attributable to employer and employee contributions. Late notification may result in incorrect withholding which is usually costly to correct. Since the cost of correcting and adjusting payments as a result of late notification will be charged to the customer, prompt attention to this matter is essential. Legislative & Regulatory Information In 2004, the IRS issued a Ruling (Rev. Rul ) that gives employers the opportunity to design a disability income insurance plan that allows employees to choose each year whether or not they want to receive disability income benefits tax-free. Such a plan would include different classes of employees - those that choose to include the long term disability income premiums in their gross income (and thereby receive any benefits tax-free), and those that do 2012 Metropolitan Life Insurance Company

2 2 not. If an employer implements this type of disability insurance plan, the employer may no longer have to calculate taxable percentages each year as required by the 3-year look back rule. The employer s new plan may provide that an employee s initial choice will carry over from year to year unless the employee makes a change. The IRS Ruling also permits an employer to design the plan with an automatic employee after-tax choice (i.e., to include the disability insurance premiums in an employee s gross income) unless the employee elects otherwise. Newly-hired employees must make an irrevocable election for the balance of the plan year in which they are hired. If an employee elects after-tax payment of disability income premiums, the employer will allocate the employee s pro rata share of the total group premium and include that amount in the employee s gross income for that year. An employee cannot elect to have only a portion of the premium paid on an after-tax basis. This IRS ruling does not completely eliminate the "ratio" or "three-year look back" method of calculating the taxable portion of disability benefits. This method of calculating the taxable portion of disability benefits is still applicable to contributory plans. 1 In order for MetLife to be able to withhold the proper amounts of employment and income taxes from disability benefit payments made in the upcoming year, it is essential that we know BEFORE November 1 of each year, whether the allocation for the next year is different from the allocation for the current year. When the allocations are submitted, it is necessary that the correct coverage (STD, STD/LTD, LTD), Group (or Report) number(s), Subcode(s) (or Subdivision(s)), and Subpoint(s) (or Branch(es)) are provided as well. Reporting Requirements - Amount Attributable to Employer Contributions Under the Internal Revenue Code (IRC), that portion of disability income benefits received by an employee which were paid for by the employee s own after-tax contributions are excludable from the employee s gross income (i.e., they are not subject to income tax). However, if those benefits are paid for by employer contributions that were not previously included in the employee s gross income, the benefits are subject to income tax. The IRS regulations require the taxable portion of disability benefits to be determined on a class basis. The allocations for a core buy-up plan must be done at the class level (all employees in the buy-up are in one class). The employees that have not elected the buy-up are a separate class. All employees in a defined class will have the same portion of their benefits taxed. The percentage of the benefit which is taxable cannot be calculated at the individual employee level. Employer-paid disability income benefits are generally subject to federal income tax (FIT), state and local income taxes, Social Security and Medicare (FICA) taxes, federal unemployment tax (FUTA), and state unemployment taxes (SUTA) when benefits are paid during the month that includes the last day that the employee was at work, and during the next six full calendar months. If a disabled employee returns to work for any period of time (e.g. one day) and then becomes disabled again for the same or a different reason, the employee will need to start a new six full calendar months 1 See 26 CFR (c). Employers that currently have a contributory plan and are considering amending their plans to be like the plans described in IRS Rev. Rule should see IRS Private Letter Rulings (PLRs) and and consult with their tax advisors to determine if the three-year look back calculation would continue to apply for some period after amendment of their plans.

3 3 withholding period. Even employer-paid LTD plans with a six-month waiting period are generally subject to at least some FICA, FUTA and SUTA tax. However, they are always subject to FIT. The IRC specifically addresses withholding and reporting of disability income benefits paid by a third party (such as an insurer). If the plan is contributory (i.e., pre- and post-tax contributions are used to pay premiums), the employer s report to the employee and the IRS of benefits paid (on Form W-2) must show the portion of benefits attributable to employer contributions (which are included in gross income) and post-tax employee contributions (which are excluded from gross income). IRS regulations sets forth the rules under which this proration is to be made. Who Determines the Allocation? The IRS regulations require the taxable portion of the benefits to be calculated based on the ratio of premiums paid that are attributable to pre-tax employer contributions to total employee/employer contributions. The employer is the only party in possession of sufficient information to ascertain not only the net premium or net cost of the plan, but also the total after-tax employee contributions actually paid during the periods involved. IRS regulations require the taxable portion of disability benefits to be determined on a class or plan basis. 2 If an employer has officially adopted one disability plan, and has only communicated one plan to employees, then only one calculation is generally used to determine the taxability of benefits regardless of how many different types of benefit are offered under the plan. Generally, the only time more than one calculation should be used is when (1) different employer/employee contributions are made by different groups of employees, and (2) the amount of employer and employee-paid premium attributable to each group is known. In these circumstances, a class by class calculation should be done. Individual calculations are generally not permitted because it is rare for an individual to qualify as his/her own class. Which Costs and Contributions Are Used? If a plan also provides benefits other than disability income benefits (such as life insurance, medical or dental expense benefits, retirement benefits, etc.), only the employee contribution and the net premium (or the net cost) for the disability income benefits portion of the plan should be considered. However, if the employer/employee contributions for the disability income benefit plan cannot be ascertained alone, then the proration determination is based on the employer/employee contribution to the cost of the entire plan. What Period of Experience Is Used? Plans with Three or More Years of Experience: If the plan has been in existence long enough to have three full policy or plan years of experience as of January 1 of the calendar year for which the calculation is made, then the last three policy or plan years are used. This means that the prorate must be recalculated each year, using the appropriate policy or plan years. The net premium for 2 See 26 CFR

4 4 each policy or plan year is determined after adjustments for dividends or retrospective premium payments. To determine the prorate to be used for benefits paid in the upcoming plan year, the employer must look at the figures actually available as of January 1 of that year, for the previous three full policy or plan years. If the contributory plan is insured and the policy year runs from November 1 to October 31, the final figures for the year ending October 31 would not actually be known as of the following January 1. Therefore, the employer would use figures for the years ending October 31 of the prior three plan years. If the plan is self-funded (ASA) and the final figures for the three prior plan years ending October 31 will be known by the following January 1, the figures for those years should be used to determine the allocation of benefits paid in the upcoming plan year. Apparently, the regulation presumes that accurate data for non-insured plans is available sooner than it would be for insured plans. The rules regarding the allocation of employer/employee contributions apply in cases of self-funded plans regardless of whether the benefits are provided directly by the employer or through a third party (such as an IRC Section 501(c)(9) trust). It should be noted that if benefits are provided directly by an employer (that is, through a self-insured arrangement without the use of a Section 501(c)(9) trust) then they are subject to mandatory withholding and reporting of FIT. Plans With Less Than Three Years of Experience: If the plan has less than three years of experience ascertainable as of January 1 of the upcoming year, then the employer may select one of the following periods for the allocation of employer and employee contributions (The net premium for each policy or plan year is determined after adjustments for dividends or retrospective premium payments): (a) the two previous policy or plan years; or (b) the prior policy or plan year; or (c) for insured or excess risk plans with less than one year of experience, a reasonable estimate of net premium and/or cost for the first policy year; or (d) for insured or excess risk plans with less than one year of experience, the actual net premium and/or cost for the first policy year if that amount can be ascertained during the calendar year; or (e) for self-funded plans (ASA) with less than one year of experience, the entire period for which experience is available, or the last full quarter or the last full month, or such other period as may be appropriate. It appears the employer should select the period providing the longest experience possible. The Computation For each policy or plan year (as indicated above), the employer determines the total net premium for the disability benefit coverage (or package of coverage including the disability benefit coverage) after retroactive premium adjustments (such as dividends, credits, and retrospective premium payments) have been made. For self-funded plans, the employer determines the net cost for the disability benefit coverage for each plan year. The employer then determines either: (1) the amount of employer contribution for the coverage in each year in question; or (2) the amount of after-tax contributions by the employees in those same years. The employer may use whatever amount is more readily available.

5 5 The amount of employee contributions for each year is subtracted from the total net premium to determine the total employer contributions (or vice versa) for each year. Then, the three-year totals of net premiums, employee contributions and employer contributions are determined. Finally, the ratio of total employer contributions to total net premium or net cost is applied to all disability benefits paid to employees during the calendar year to determine what portion of benefits are includable in an employee s taxable income. If a plan provides both short and long-term disability income benefits, and the ratio of employer to employee contributions for each coverage is different, separate calculations must be made for each coverage. These calculations must be made each year using figures for the last three policy or plan years. A simple worksheet to assist in making this computation is found on the last page of this release. If you have more than one plan, simply use a photocopy of the worksheet for each affected plan. Special Rules for Pre-Tax Contributions Under Cafeteria Plans Some employers maintain STD, STD/LTD or LTD plans pursuant to cafeteria arrangements. Some of the arrangements permit employees to contribute to the cost of this disability income coverage on a pre-tax basis. If employee contributions to these disability income plans are made with pre-tax dollars, then any employee contribution is deemed to be employer funds for purposes of determining the employee/employer contribution ratio. Variations on the General Rule Classes of employees: If the plan has different contribution arrangements for different classes of employees, separate determinations must be made for each class. EXAMPLE: An employee in Class A contributes to the cost of its disability plan. An employee in Class B does not. If possible, the employer must make a separate determination for the class of employees who contribute to the plan (in this case, employees in Class A only). However, if it is not possible for the employer to isolate the allocation for the class of employees who contribute, then the determination is made for all employees under the plan and that determination is used for all employees. Employer-Pay-All Plans: No allocation is required. The entire benefit is includable in each employee s taxable income and is subject to income tax. A contributory plan provided under a cafeteria plan where the employee contributions are made with pre-tax dollars is treated as an employer-pay-all plan for this purpose. Employee-Pay-All Plans: No allocation is required if premiums are paid by employees on an aftertax basis. In this case the entire benefit paid is excludable from each employee s taxable income and is not subject to income, Social Security or Medicare tax. Obviously, in these cases there should be no program of voluntary withholding and mandatory reporting. Employers with after-tax employee-pay-all plans should be identified as soon as possible so that unnecessary work regarding their plans may be avoided.

6 6 Other Variations: Based on IRS guidance, changes to a plan generally will not qualify as the establishment of a new plan unless the changes significantly impact the coverage provided or the benefits available to the class of employees who participate in the plan. In addition, employers seeking to establish a new plan should have that plan approved by whatever governing body approves their benefit plans and the new coverage should be communicated to employees as a separate or new plan, not just as changes to the existing plan. Employers should always consult with their tax advisor to determine whether or not the changes in coverage being contemplated will qualify as a new plan. Also see discussion above of IRS Rev. Rule and Legislative & Regulatory Information Release LI-266 for more information on new plans. The regulations do not deal with other variations. Employers whose circumstances are not described in this release or in the applicable IRS regulation should consult with their own legal counsel. This release provides general information only. Case specific problems should be handled by the customer s own tax advisors. Additionally, extensions of the date allocations are due cannot be granted. Reporting to Employees - IRS Form W-2 The employer must furnish IRS Form W-2 to both the employee and the IRS. Form W-2 must show that portion of disability benefits excluded from the employee s gross income (that is, the portion attributable to post-tax employee contributions) in Box 12. The employer must identify these amounts by entering J and the amount excluded from wages in Box 12. The benefits included in the employee s gross income (the portion attributable to employer contributions) is to be shown in Box 1, Wages, tips, other compensation. The report of third party sick pay benefits may be included on the same Form W-2 which reports wages and other earnings paid by the employer or provided on a separate Form W-2. In either event, the Form W-2 must be furnished to the employee by January 31 of the year after the calendar year in which the benefits were paid. Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, any U.S. Federal tax information contained in this release (including any attachments) is not intended to (and cannot) be used by anyone to avoid IRS penalties. It is intended to support the sale of MetLife insurance products. Our customers should seek advice based on their particular circumstances from an independent tax advisor. This LEGISLATIVE & REGULATORY INFORMATION release is not intended to supply legal advice or to offer solutions to individual problems. Those who require such advice should consult their attorneys.

7 7 Worksheet Indicate Coverage (STD or LTD) Indicate Class Covered (e.g. Executives, Salaried or Hourly) (1) Policy or plan year (2) Total net premium or net cost (A) (B) (C) (D) Year ending / / 20 Year ending / / 20 Year ending / / 20 $ $ $ $ Totals Minus: (3) Total post-tax employee contributions $ $ $ $ Equals: (4) Total pre-tax / employer contributions $ $ $ $ (5) Ratio of employer contributions to net premium or net cost line 4-column D = = line 2-column D %* *The percentage shown in item (5) is the percentage of disability benefits includable in the employee s gross income for federal income tax purposes