Third-party sick pay enables employees who are sick, injured, or temporarily disabled to receive compensation while they are out of work.
Third-party sick pay is a benefit that some companies provide for employees. This coverage, typically part of an employee’s benefits package, applies to illnesses and nonwork-related accidents. It enables employees who are sick, injured, or temporarily disabled to receive compensation while they are out of work. Third-party sick pay is made in the form of short-term or long-term disability payments.
How Does Third-Party Sick Pay Work?
Third-party sick payments are similar to an employee’s regular paycheck, except employees get a percentage of their normal gross pay. Another difference is that these checks are issued by the insurance company or third-party provider. Both the employee and employer must keep records of the payments received while the worker is away from the job.
If the third-party payer acts as the employer’s agent, then the employer is responsible for:
- Social Security and Medicare withholdings
- Federal Unemployment Tax (FUTA)
- State Unemployment Tax (SUTA)
However, the situation is different if the third-party payer is not the employer’s agent. In that case, the third party is responsible for paying the employer’s portion of those taxes. There are exceptions where one party can transfer tax liability to the other. Note also that regulations can vary between regions.
Is Third-Party Sick Pay Earned Income?
If a worker receives third-party sick pay within six months after leaving work, it’s considered earned income. This is because sick payments are made in place of regular wages. If sick leave is received more than six months after work is discontinued, it’s classified as unearned income.
Is Third-Party Sick Pay Taxable?
Yes, third-party sick pay is taxable—unless the insurance premiums are paid with after tax dollars. Depending on the sick pay plan, premium costs might be covered by the employer, employee, or both parties. Regardless of who is paying the premiums, sick pay is taxable when these premiums are paid with pre-tax dollars.
What Is Nontaxable Sick Pay?
Although sick payments are typically made with pre-tax dollars, some sick pay plans make payments with after tax dollars. If this is the case, sick pay becomes nontaxable. Sick pay is also nontaxable if death occurs during the period in which the employee is receiving third-party sick pay. Payments issued after death to an estate or survivor are not eligible to be taxed.
Four Tax Scenarios
When distinguishing between a taxable and nontaxable sick pay plan, there are four possible scenarios:
- The employer pays for the entire insurance premiums. In this case, the employee pays all of the tax for the sick pay payments.
- The employer pays for part of the premiums, and the employee pays for the rest with after tax dollars. Here, the employee pays a tax proportionate to the employer’s portion of the payment.
- The employee pays for the entire premium with pre-tax dollars. In this case, the employee pays all the tax.
- The employee pays for the entire premium in after tax dollars. The employee does not have to pay tax on the sick pay payments.
Reporting Sick Pay
It’s important to note that sick pay must be reported on the employee’s W-2 regardless of tax implications. The employer or, in some situations, the third-party payer is required to document the following information:
- Sick pay used
- Federal income tax withheld from sick pay
- Sick pay subject to employee Social Security tax
- Social Security tax withheld from sick pay
- Sick pay subject to employee Medicare tax
- Medicare tax withheld from sick pay
- Sick pay disbursed by a third party not included in income
Here’s an example from the IRS explaining how an employee might report sick pay and change federal income tax withholding if they received payments during 2022:
|Dave, an employee of Edgewood Corporation, was seriously injured in a car accident on January 1, 2022. Dave’s last day of work was December 31, 2021. The accident wasn’t job-related.
Key, an insurance company that wasn’t an agent of the employer, paid Dave $2,000 sick pay each month for 10 months, beginning in January 2022. Dave submitted a Form W-4S to Key, requesting $210 be withheld from each payment for federal income tax. Dave received no payments from Edgewood, his employer, from January 2022 through October 2022. Dave returned to work on November 1, 2022.
For the policy year in which the car accident occurred, Dave paid a part of the premiums for his coverage, and Edgewood paid the remaining part. The plan was, therefore, a “contributory plan.” During the 3 policy years before the calendar year of the accident, Edgewood paid 70% of the total of the net premiums for its employees’ insurance coverage, and its employees paid 30%.