What is third-party sick pay (3PSP), and how does it work?
What is third-party sick pay?
Third-party sick pay is an employer-sponsored insurance benefit that provides payments to employees in place of lost wages due to absences caused by an illness or non-work-related injury. Employees covered under an insurance plan offered by their employer, like Short-Term Disability, Long-Term Disability, etc., typically receive payments directly from the third-party insurance carrier.
These disability payments are also known as third-party sick pay, and employees typically receive a percentage of what they would have earned if they were working. In rare cases, some "self-insured" companies may manage this function internally, eliminating the third party.
How is the taxability of third-party sick pay determined?
The taxability of third-party sick pay payments received by employees is based on who pays the insurance premium and how any employee payroll deductions for their portion of the premiums are handled.
- If the employer pays the entire premium for the applicable insurance plan, any sick payments received by the employee from the third party are 100% taxable to the employee
- If both the employer and the employee pay portions of the premium AND the employee pays their portion with after-tax dollars, i.e., a post-tax payroll deduction, any sick pay payments received by the employee from the third party are taxable in the same proportion of the premium paid by the employer
- If the employee pays the entire premium with pre-tax dollars, i.e., a pre-tax payroll deduction, any sick pay payments received by the employee from the third party are 100% taxable to the employee
- If the employee pays the entire premium with after-tax dollars, i.e., a post-tax payroll deduction, any sick pay payments received by the employee from the third party are NOT taxable to the employee
How do the payments to employees get processed?
The third party that issues sick payments to your employee will withhold employee taxes from the payments, which typically will only be FICA taxes, i.e., Social Security and Medicare. An employee can choose to have the third party withhold Federal Income Tax (FIT) by filling out IRS Form W-4S and submitting it to the third party. The third party will typically deposit the taxes withheld from the employee directly to the IRS and report the employee tax amounts on their quarterly forms 941.
The handling of the applicable deposits and reporting of the employer taxes related to each third-party sick payment is determined by the specific arrangement your company has agreed to with the third party. The taxability for employer taxes is calculated based on the same factors as the employee taxes. Whatever portion of the third-party sick payment is taxable to the employee will be taxable for the following Federal Employer Taxes: Social Security, Medicare, and FUTA. The taxability for State Employer Taxes, i.e., SUTA, depends on the rules for each specific state, and you, as the employer, are responsible for ensuring the proper wage and tax reporting occurs.
For more information on the tax reporting requirements related to third-party sick pay, please review the following article: Reporting Requirements for Third-Party Sick Pay