Third-party sick pay consists of compensation for employees who are sick or injured. It is paid by a third party, such as an insurance company, rather than the employer. If your business is considering offering third-party sick pay payments, it is important to understand tax implications, your responsibilities, and how third-party sick payments are reported.
What you’ll learn
What you’ll learn
Key takeaways
- Third-party sick pay can assist employees who are absent from work due to illness, a medical condition, or an injury
- Employers are responsible for reporting third-party sick pay, even if the payments are made by a third-party insurer
- Third-party sick pay is sometimes referred to as short-term disability insurance or short-term disability payments
This guide will help you understand the meaning of third-party sick pay, as well as the ins and outs of how it works.
What is third-party sick pay?
In a few words, third-party sick pay is money that is paid to an employee when they are temporarily absent from work due to an injury, sickness, or disability. It doesn’t include disability retirement payments or medical and hospitalization expenses. Third-party sick payments can cover the gaps for employees who are unexpectedly out of work and serve as a highly desired employee benefit.
Unlike employer-paid sick leave, which is funded by your business, third-party sick pay is handled by a third-party payer such as an insurance company or a trust. It works like an insurance premium for employees in need.
When and why employers use third-party sick pay
There are a variety of reasons that small businesses turn to third-party sick pay, including the following:
- Third-party sick pay is a great perk for your employees to receive wage continuation during an absence that extends beyond your company’s standard sick leave. Workers will usually receive a percentage of their typical pay
- Using a third party to administer this benefit reduces the burden for your HR team
- A third-party administrator can handle processing, payments, compliance, risk management, and more, taking all this work off your plate
- Companies offering third-party sick pay expertise have the specialized experience and know-how that increases processing speed while reducing errors
Ultimately, third-party sick pay can be a successful part of managing your disability benefits without all the work.
Is third-party sick pay taxable?
Many business owners wonder if third-party sick pay is taxable. The answer is usually “yes.” Sick payments are typically subject to Medicare, Social Security, and federal unemployment taxes.
If your company paid for the full premium for the sick-pay benefit or if your employee paid for the full premium with pre-tax dollars, those payments are 100% taxable for the employee who received them. They are not, however, taxable if your employee paid for the benefit with after-tax dollars.
However, if the employee paid for a portion of the sick plan with after-tax dollars, that percentage would not be taxed. For example, if one of your employees paid 25% of the benefit and you paid the remaining 75%, then only $750 of a $1,000 tax payout would be taxable.
The third-party insurer is responsible for withholding required taxes and the employee’s portion of Medicare and Social Security taxes, unless your business has agreed to accept liability. In addition, the third party must request information from your business to rule out items that aren’t subject to employment taxes. They will ask you for total wages paid for the employee, the last month worked, and the employee’s after-tax contributions to the sick-pay plan.
There’s a lot to keep track of with third-party sick pay, so we put together a simple table below to help you see how the major pieces fit together.
| Topic | What it means |
| What third-party sick pay is | Payments made to an employee by an insurance company or other third-party administrator when the employee is out due to illness, injury, or disability. |
| Who pays the taxes | The third-party insurer usually withholds the employee’s Social Security and Medicare taxes. Employers still pay their employer share of these taxes. |
| When payments are taxable | Sick pay is taxable if the employer paid the full premium or if workers paid premiums with pre-tax dollars; partly taxable when employees pay part of the premium with after-tax dollars. |
| What employers must report | Employers must include third-party sick pay on the employee’s W-2 (Box 12, Code J) and file Form W-3. Employers also report their share of taxes on Form 941. |
| What third-party payers report | Third-party payers deposit withheld taxes and request wage and contribution details from employers to determine taxable amounts. |
Employer responsibilities for third-party sick pay
When it comes to third-party sick pay, it is critical for your business to comply with payroll rules and regulations, or you could see a hefty fine down the road. As part of their annual W-2 reporting, employers are responsible for reporting third-party sick payments on behalf of the employees who received them at year-end.
The third party must deposit withheld taxes, and your business must also deposit your portion of Medicare and Social Security taxes, using Form 941, the Employer’s Quarterly Federal Tax Return. To this end, you must coordinate with third-party providers to ensure timely and accurate reporting.
Reporting third-party sick pay for payroll and compliance
Keep these three key things in mind when you are reporting third-party sick pay for payroll and compliance:
- How third-party sick pay appears on W-2 forms: When completing W-2 forms, third-party sick pay is reported in Box 12, Code J
- Employer vs. third-party reporting obligations: Both businesses and third-party insurers have different reporting obligations for third-party sick pay. Ensure that your HR team is on top of reporting to avoid penalties and confusion. Employers must annually file W-2 forms with sick pay information, along with Form W-3
- Adjustments and corrections: While adjustments and corrections can be made after the fact, it is always better to get it right the first time. Proper recordkeeping is an essential component of your company’s compliance programs. If you are struggling with numerous adjustments and corrections, you might benefit from working with an HR pro who can manage this process for you
Common challenges and considerations
The most common challenges and key considerations for third-party sick pay are as follows:
- Tax withholding complexities: If you don’t have a tax pro in your office or working with you as a partner, you may struggle with the tax complexities that naturally come with third-party sick pay. It is important to get taxes and compliance right the first time, so you aren’t faced with penalties down the road
- Impact on Social Security and Medicare taxes: Your company will also need to adjust Social Security and Medicare taxes based on third-party sick payments made each year
- Addressing reporting errors and adjustments: If you have any reporting errors or need to make an adjustment, this can be a hassle. You may need to update taxes owed or submit amended tax returns
Flexibility when you need it most
We value having a system that is both powerful and simple to use, and that provides timely customer service, both online and via email. As a small business, we especially appreciate that these qualities come with much greater affordability. The ability to be responsive to any employee need, from running an interim payroll to making simple profile changes, makes all the difference.
— Douglas Schuessler, Montgomery Soccer, Inc.
Best practices for managing third-party sick pay
These best practices will keep you ahead of the game when it comes to managing third-party sick day:
- Focus on effective payroll integration: The more manual processes you can reduce or eliminate, the better. When you can integrate your third-party sick pay and other HR processes with your payroll, you will save time and money while increasing accurate reporting
- Communicate with employees about sick pay: Let employees know their options in terms of sick pay and extended leave. This should include overall costs, tax implications, timelines, and anything else that will impact their overall finances
- Ensure compliance with tax laws: This is a must. Make sure that you are aware of national and local tax laws impacting sick pay and short-term or long-term disability payments
Third-party sick pay is a powerful perk that employers can offer
Should an employee need time away due to illness or injury, third-party sick pay can provide peace of mind (and has benefits for employers, too). Workers can receive wages even when they need time away from the workplace to recover without having another worry added to their plate. On the other hand, employers can use this perk when recruiting job candidates, and it can be a way to retain employees.
OnPay can help you efficiently manage third-party sick pay and other employee benefits efficiently and easily sync with payroll software to assist you with supporting employee health, wealth, and happiness. If you are ready to streamline your HR work, contact us today to get started with OnPay.
Take a tour to see how easy payroll can be.
Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.