When an employee receives payment from someone who isn’t their employer while they’re out on sick leave, it’s called third-party sick pay. Even though employers don’t pay it, there are tax and reporting obligations they must follow.
Companies that forget about these obligations until the end of the year are putting themselves in a bad spot.
In other words, third-party sick pay can be a sneaky problem if you aren’t ready to deal with it. Here’s everything you need to know to stay on top of third-party sick pay.
How Third-Party Sick Pay Works
Sick pay is compensation that employees receive when their health needs—or those of their dependents—compel them to stay home from work. It covers short-term things like fevers, stomach viruses, and bad colds. But it also covers longer-term leave for things like surgery, mental health complications, or injuries.
It’s important to point out that sick pay is not the same as workers’ compensation insurance. Workers’ comp can only be applied when an employee suffers a job-related injury or illness.
The federal government doesn’t require employers to pay for sick leave. But a growing number of states do. In our opinion, everyone should offer paid sick leave or a generous PTO policy that gives plenty of room for sick time and vacations alike.
If you offer paid sick leave that’s separate from your PTO policy, you can either administer your own sick pay plan or contract it out.
If you contract the sick pay plan administration out to someone else, the sick pay is made by a third party.
With third-party sick pay, employees usually receive a percentage of their usual pay during the time they’re away. Sometimes, the payments stretch out over the course of weeks or months, depending on the reason the employee is on sick leave.
Third-party sick pay is not the same as worker’s compensation. Instead, third-party sick pay is used for non-workplace-related injury, illness, and disability.
Say a nurse breaks her leg while she’s out hiking with friends over the weekend. Her injury requires surgery so it can heal correctly. Her doctor tells her to stay off her feet for several weeks after the procedure.
This means she can’t work during those three or four weeks. That means the nurse would probably qualify to collect third-party sick pay while she’s on a leave of absence recovering from the injury.
In another scenario, an overwhelmed accountant might struggle with severe depression during the winter months. He checks into a hospital for treatment. He’s released a week later but is advised to take three more weeks off to attend therapy and adjust to a new medication.
He’d most likely be able to collect third-party sick pay during this time.
4 Simple Steps to Stay on Top of Third-Party Sick Pay
Third-party sick pay can be confusing to keep track of, but with these four simple steps, you’ll be ready for anything. Come back to them whenever an employee begins collecting third-party sick pay.
1. Understand Who Is Responsible for Payments
With any form of sick pay, there are three potential entities who will pay it: the employer, an agent of the employer, or a third party who is not an agent of the employer.
Only two of these entities would count as third-party payers. According to the IRS, third-party sick pay happens when the payer is an agent of the employer or a third party who is not an agent of the employer.
Let’s take a closer look at these two types of third-party payers.
The IRS states that “a third-party payer is an employer’s agent if the third party bears no insurance risk and is reimbursed on a cost-plus-fee basis for payment of sick pay and similar amounts.” Many third party administrators (TPAs) are considered employer’s agents.
A TPA is not an insurance company, so it doesn’t carry any insurance risk. Instead, it’s an agency that manages an employer’s relationship with the insurance company that does carry the risk. A TPA files sick pay claims on behalf of the employer and pays those benefits out after receiving them from the insurance provider.
When third-party sick pay is handled through an agent of the employer, whether it’s a TPA or some other organization that carries no insurance risk, the employer is responsible for withholding the taxes.
But if the sick pay is paid directly by an insurance company or other organization that bears insurance risk, that organization is responsible for paying the employer portion of FICA and FUTA taxes.
However, these rules aren’t 100% rigid. Tax liability can be passed from one party to another depending on the circumstances and on federal, state, and local laws.
2. Determine Tax Liabilities
Knowing who is liable for paying taxes on third-party sick pay is key. In most circumstances, taxes must be paid on third-party sick pay. It’s a type of employee compensation. And who pays that tax depends on how the sick plan is funded.
There are four separate scenarios that could play out:
- Employer does not pay into the policy, employee pays the premium with pre-tax dollars: In this case, since the employee does not pay taxes on the premium before it’s paid to the company, the sick pay is 100% taxable to the employee.
- Employer does not pay into the policy, employee pays the premium with post-tax dollars: If the employee uses post-tax dollars to pay the policy premiums, there’s no need for them to pay taxes on sick pay paid out from the policy.
- Employer pays 100% of the policy: In this case, the employer’s payment of the premium counts as a taxable benefit for the employee when sick pay is paid out. Employees would therefore be 100% responsible for these taxes.
- Employer and Employee both pay into the policy: In this scenario, the employer does not pay taxes but the employee does. Let’s say an employer pays 60% of the premium for a sick leave policy and the employee pays the other 40%. When sick pay is used, the employee would pay taxes on 60% of the total amount paid out—equivalent to the employer’s portion.
If the sick pay is taxable, then employers—or insurance-risk-bearing third-party payers—must pay their portion of FICA and FUTA taxes. They must also withhold the appropriate amount of Social Security, income tax, and Medicare from their employees’ sick pay.
3. File the Third-Party Sick Pay Recap (Form 8922)
The Form 8922 is tailored specifically to reconcile tax returns with W-2 forms when an employee receives third-party sick pay.
Here’s why it’s necessary. An employee’s W-2 form will tell the IRS whether or not the employee collected third-party sick pay.
But it doesn’t provide space for the employee to explain:
- Who was responsible for withholding (and filing) the taxes—the employer or the insurer
- How much of the sick pay was subject to federal income, Social Security, and Medicare tax
- How much federal income, Social Security, and Medicare tax was withheld from the sick pay
A Form 8922 collects all of this information, supplementing the employee’s W-2.
So who’s responsible for filing the Form 8922?
It depends on what the Form W-2 looks like for that employee. If the sick pay is reported on the W-2 under the third party’s EIN and name, the employer is responsible for filing a Form 8922.
But if the sick pay is reported on a W-2 under the employer’s EIN and name, the third party must file a Form 8922.
Keeping these instructions straight can get complicated. Nothing’s less fun than trying to disentangle the dry language of the IRS. If tax time comes and you feel confused about how to report and file third-party sick pay, reach out to a tax professional for help.
4. Alert Your Payroll Provider
If you wait until the end of the year to get your payroll provider your third-party sick pay information, it increases the chances of a mistake on a W-2. Which, in turn, increases your chance of getting a massive, chronic headache during tax time.
That’s why it’s wise to alert your payroll provider or in-house payroll team right away when an employee starts receiving third-party sick pay.
This gives them plenty of time to sort out the details and feel prepared for the wild ride that is tax season.
