What Are The Pros And Cons of “Grossing Up” Employee Salaries With Short Term Disability Plans?

Hi Bud,
I just worked with our insurance broker to put in place an employer paid short term disability plan. While getting this set up he strongly encouraged us to go with a non-taxable plan and “gross-up” our employees’ salaries to cover the deduction, he stated it would in turn be a better benefit to the employees.
My question to you is, what are the pros and cons of “grossing – up” salaries and is it a common practice for employers to do this with short term disability plans?
Ultimately, our broker was not able to provide enough information on this practice and our payroll department was unfamiliar so we went with a taxable plan and paid the full cost for our employees. However, I would love to be prepared with more information before we need to renew.
Grossing Up And Disability Alert

Dear G.U.A.D.A

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I’m sorry you weren’t able to activate your Short Term Disability (STD) policy in a non-taxed environment for your employees. However, I’m thrilled you’ve taken the advice I give my clients and added the Short Term Disability plan, regardless of the taxable consequences.  Having an Income Replacement source in case of an injury or accident is a vital asset in today’s world.
To help answer your question, let’s lay the framework for making the Short Term Disability benefits, should a claim occur, to be received tax free.
First, understand the IRS principal that if we receive income, we must pay tax on it.  With disability plans that generate income, should you have a claim, you receive replacement income as if you were getting paid by your Employer.  The IRS rules state that if the Employee pays the Short Term Disability premium with dollars that have previously been taxed (after-tax dollars), then the income derived at claim time will pass to the Employee without the requirement to pay tax.
In your circumstance now, you as Employer are paying the Short Term Disability premium and deducting that as an expense of the business.  Since your Employees receive the benefits without having to pay anything for it, the IRS treats the income derived from the Short Term Disability claim as if it came from the Employer, and the Employee must pay tax on that income at the end of the taxable period (usually year end).  The Employee that has an Short Term Disability claim will generally receive a W-2 directly from the insurance company at year end.  Occasionally, the insurance carrier will provide the Employer a list of claims, and the Employer will include the Claim amounts as Other Income on the Employee’s W-2 at year end.
Now, to avoid the Short Term Disability claim income being taxed, the Employer and the Employee came up with a scheme, recognized and accepted by the IRS as a means to avoid paying tax.
How does it work?  It’s really a very simple trick.  
Instead of the Employer paying the premium and deducting the premium as a business expense, the Employer simply raises the pay of each Employee by an amount equal to that person’s Short Term Disability premium. The Employer then deducts the Short Term Disability premium from each Employee’s after-tax pay and pays the premium deducted to the insurance carrier.  Employer deducts the amount of the “grossed up” pay as Employee wages.  This process is called “grossing up” and is legally recognized as an effective way for Employees to receive their Short Term Disability claim income tax free.
Some carriers charge an additional fee on the Short Term Disability premium (3-5%) for providing the after-tax list bill to the Employer. This same process is also very commonly used for Long Term Disability (LTD) premiums.
So, the rule of thumb to follow is: If Disability (STD or LTD) premiums are paid pre-tax, then benefits will be taxed. If premiums are paid by Employees with grossed up income after taxes have been paid, then benefits will be tax free at filing time.
Your broker should be able to get your carrier to switch the premiums whenever you can get the changes to payroll accomplished, and surely by your next Open Enrollment.