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The 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.
In reliance 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 agreed:
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.
....Payments under 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.
Under the 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.
A. Christopher Wieber is a New York lawyer who advises individuals with regard to claims under ERISA short and long term disability insurance plans, as well as claims under privately purchased business overhead expense and disability income insurance policies.