A recent ruling from the U.S. Tax Court, Gentile v. Commissioner of the Internal Revenue
Service, T.C. Memo. 2010-254 (Nov. 18, 2010), available here, confirms that the
settlement of a claim for disability benefits under an employer-sponsored ERISA long term disability
plan, is taxable when the contributions for the plan were made by the employer.
petitioner, Donna Gentile, was employed by the Orange County Register. Her employer provided
group long term disability insurance issued by Unum Life Insurance Company of American
("Unum"). As is the case in many ERISA long term disability plans, her employer
"paid the entire premium under the Unum disability policy" and "Mrs. Gentile was not
required to pay any portion of the premium or to include (and did not include) any portion of the
premium payment in her gross income."
Based on a back injury in December, 1992,
Ms. Gentile made a claim for benefits under the Unum long term disability plan in October,
1994. Under the terms of the plan, she was potentially entitled to a disability benefit that
was 60% of her basic monthly earnings, payable to age 65. Unum denied the disability claim on
the ground that the notice and proof of claim were too late. Pursuant to her rights under
ERISA, Mrs. Gentile thereafter filed a lawsuit in 1996. In December, 2005, after protracted
litigation and settlement negotiations, Unum agreed to make a lump sum payment of $333,647.46 to
conclude the lawsuit and settle the entirety of Mrs. Gentile's disability claim.
on alleged communications with the IRS and their accountant, Mr. and Mrs. Gentile concluded that
they were not required to report or pay taxes on the lump sum settlement of the Unum disability
claim. In fact, however, when the IRS learned about the circumstances of the lawsuit and the
settlement of the disability claim, it insisted that tax was due. The U.S. Tax Court
Section 105(a) [of the IRS Code] provides that amounts received by an
employee through accident or health insurance for personal injuries or sickness shall be included in
gross income to the extent that such amounts (1) are attributable to employer contributions that
were not includable in the employee's gross income, or (2) were paid by the employer. Section
105(c) provides an exception.... Section 105(c)(2) itself has two requirements: (1) The payments to
the taxpayer must be computed with reference to the nature of the injury; and (2) the payments must
be computed without regard to the period the taxpayer is absent from work.
the UNUM disability policy, even if in the form of a lump-sum settlement, are designed to replace
the income an employee lost due to a disability and are computed with regard to the employee's
absence from work. Accordingly, on the basis of the record, the Court finds that the lump-sum
settlement payment to Mrs. Gentile fails the requirements of section 105(c)(2) because it was
computed arithmetically with reference to Mrs. Gentile's absence from work and not to the nature or
severity of her injury.
In sum, the court held that the lump sum
settlement of Mrs. Gentile's long term disability claim was taxable as income in the year it was
received. It also held that "[a]lthough ... petitioners would normally be able ... to
offset against such income any miscellaneous itemized deductions, for fees paid to attorneys and
expert witnesses, subject to the 2 percent of adjusted gross income limitation under section 67(a)
and the alternative minimum tax under section 55," Mrs. Gentile "had not provided
sufficient evidence to substantiate the offset of such deductions against the lump-sum settlement
payment" of her disability benefit.
The Gentile case underscores several
tax-related considerations which claimants receiving disability income or long term disability
benefits should bear in mind. Subject to narrow exceptions, disability benefits from an
employer-paid long term disability plan will generally be taxable in the year received. In
contrast, where the employee bears the cost of the disability insurance (or if an individual
purchases a private disability income policy), benefits are generally not taxable. Finally, if
disability benefits are taxable in the first place, the lump sum settlement of a disputed claim
about those disability benefits will itself be taxable as income in the year received. The tax
consequences of such a settlement can be quite considerable, particularly in comparison to the tax
effect of receiving disability benefits on the normal monthly payment schedule.
circumstances, a claimant entitled to long term disability benefit payments should be extremely
careful before accepting a lump sum settlement offer. Optimally, a claimant who is considering a
lump sum settlement of a disability claim will obtain the advice of a lawyer, tax accountant, and
investment adviser to ensure that such a settlement is in his or her best interest.