There is case law to suggest that if an employee pays for his disability premiums and the employer "grosses-up" the employee's salary to cover the amount of the disability insurance payments, the disability benefits are still taxable to the employee.

Any tax experts out there? Why are the benefits taxed. Is this an imputed income situation?

Or can the employee, legally, receive the benefits tax-free?

Would a top-hat plan, or a different plan design be an alternative?

Any help would be appreciated

I'm not a tax expert but I do know that when an employer provides and pays for the disability insurance the disability benefit received by the employee is then taxable to the employee. This includes an instance when the employee pays for the insurance on a pre-tax basis. When the employee pays with after tax dollars for the insurance the benefit is not taxable.

See IRS section 105(a) as it relates to disability payments from employer paid premiums.

www.irs.ustreas.gov May help

The Treas Regs would expand 105(a) further. See Treas Regs. 1.105-4, 7.105-1 and -2.

Actually, the IRS just took a look at a similar scenario in which the employer paid for the LTD coverage, but included the cost of the premiums in the participant's gross income and the benefits were found non-taxable. Shoot me an email to discuss further. Take Care!

This PLR 200204021 might explain best:

http://www.irs.ustreas.gov/pub/irs-wd/0204021.pdf

The opinion letter is Perfect !!!!! Right on point.

This is belated but sincere..... thank you very much.