US UK Tax Returns Preparation: Income Protection Payouts

Income protection and critical illness payouts are often tax free in the UK yet taxable in the United States, because each country asks a different question about who paid the premiums. Accurate US UK tax returns preparation therefore starts with the premium history, not the payout, and tests every policy against both HMRC and IRS rules.

Why a payout that is tax free in the UK can still belong on a US return

A senior American executive in London, or a US partner in a UK firm, who is signed off work with a serious illness is rarely thinking about tax. The policy pays, the UK position is usually simple, and the money arrives either through payroll or straight into a current account. What tends to be missed is that a US citizen or green card holder files on worldwide income, and the US tax code decides whether an insurance benefit is taxable by reference to a completely separate set of tests.

At Jungle Tax we see the same pattern in catch-up files again and again: the UK side was handled correctly by payroll or simply ignored because nothing was due, and the US return either omitted the benefit altogether or reported it in a way that cannot be supported. Neither outcome is safe. An omitted taxable benefit is under-reported income; a tax-free benefit reported as wages is an overpayment that may be recoverable only within a limited period.

The published guidance does not help much. UK consumer pages explain the UK rules in a few hundred words and stop. US pages discuss domestic disability cover and never consider a UK policy, a P11D or PAYE. This guide sets out both systems side by side and then deals with the points where they collide.

How does HMRC tax income protection benefits?

Income protection, still called permanent health insurance in HMRC's own manuals, pays a regular income while illness or injury prevents the policyholder from working. The UK treatment depends almost entirely on who funded the cover.

Policies you pay for personally

Where an individual takes out a policy and pays the premiums from income that has already borne UK tax, the benefits are generally exempt from income tax. HMRC's Insurance Policyholder Taxation Manual at IPTM6110 sets out the conditions: no UK tax relief was given on the premiums, the policy insures a genuine health or employment risk, and it is a normal arm's-length insurance contract. HMRC confirms there is no monetary limit on the benefits that can be received tax free under this exemption. Nothing is entered on the Self Assessment return as income.

Employer-funded group income protection

Group cover works differently. The employer is normally the policyholder, the insurer pays the benefit to the employer, and the employer passes it to the employee through payroll. HMRC's Employment Income Manual at EIM06410 treats this as a funding arrangement for sick pay: the amount the employee receives is earnings, and it is subject to PAYE income tax and National Insurance contributions in the usual way. Where the insurer pays the employee directly, a separate charging provision reaches broadly the same result.

Two refinements matter for return preparation:

• The premium is not usually a taxable benefit. HMRC's manual states that the right to receive sick pay under an employer's arrangement with an insurer is not a chargeable benefit under the benefits code. For a typical group income protection scheme, therefore, nothing appears on the P11D for the premium; the tax falls on the benefit when it is paid.
• Employee contributions reduce the charge. Where the employee genuinely contributed to the cost from net pay, only the proportion of the benefit attributable to the employer's contributions is taxable. HMRC's current view is that salary given up under a salary sacrifice arrangement is not an employee contribution for this purpose, with transitional treatment for periods up to 31 December 2023 where earlier guidance was relied upon.

Employer pays the premiums on an individual policy

A third arrangement appears regularly in senior packages: the executive owns an individual policy and the employer meets the premiums. The premium is then generally taxable on the employee as employment income and reported through the P11D or payroll. Because the premium has in substance been paid out of taxed income, the benefits are generally treated in the same way as those from a personally funded policy. Where the cost is shared, HMRC's guidance apportions the result. The paperwork, not the label on the scheme, decides which regime applies.

Is a critical illness lump sum taxable in the UK?

Critical illness cover pays a single lump sum on diagnosis of a specified condition. For a policy an individual owns and funds personally, the lump sum is generally received free of UK income tax and capital gains tax. It is not earnings and it is not a return on an investment.

Employer-provided critical illness cover is commonly structured the opposite way round from group income protection. The premium the employer pays is generally a benefit in kind, reported on the P11D (or taxed through payroll where benefits are payrolled) and subject to employer Class 1A National Insurance. The employee has therefore been taxed on the cost of the cover each year, and the eventual lump sum is generally paid tax free. Scheme designs vary, and the scheme documentation should always be checked rather than assumed.

How does the IRS tax accident and health insurance benefits?

The US analysis ignores the UK labels entirely. Income protection and critical illness policies are both tested as accident or health insurance under sections 104, 105 and 106 of the Internal Revenue Code, and IRS Publication 525, Taxable and Nontaxable Income, summarises the rules in plain terms.

Section 104(a)(3): the after-tax premium test

Amounts received through accident or health insurance for personal injury or sickness are excluded from gross income, except to the extent they are attributable to employer contributions that were not includible in the employee's gross income, or are paid directly by the employer. Publication 525 puts it simply: if you paid the entire cost of the plan, the benefits are generally not income; if the employer paid, they generally are; and if both paid, only the part attributable to the employer's payments is income.

Section 105: employer-funded benefits and the narrow exceptions

Section 105(a) brings employer-funded benefits into income. Two exceptions follow. Section 105(b) covers reimbursement of actual medical expenses, which is rarely relevant to a UK income protection or critical illness claim. Section 105(c) excludes payments for the permanent loss, or loss of use, of a member or function of the body, or permanent disfigurement, but only where the amount is computed by reference to the nature of the injury and not by reference to time away from work. A monthly income protection benefit, which exists precisely to replace earnings during absence, does not fit that description. Whether an employer-funded critical illness lump sum does is a question of the policy terms and the medical facts, and it should never be assumed.

Section 106: why the employer's premium is normally left out of US income

Section 106 excludes employer-provided coverage under an accident or health plan from the employee's gross income. Nothing in the provision confines it to US employers or US insurers. For a UK group scheme, the practical consequence is that the premium is normally not US income, and the benefit is therefore normally US taxable when it is paid.

What if the UK taxed the premium as a benefit in kind?

This is the question generalist guidance never reaches, and it is where UK and US treatment most often part company.

The US exclusion depends on whether the employer's contribution was includible in US gross income. It does not depend on whether the UK taxed it. A premium that appears on a P11D has borne UK tax, but section 106 may still treat that same premium as excluded from US income. If so, the statutory condition for excluding the eventual benefit is not obviously met, even though the employee feels, quite reasonably, that the premium was paid from taxed money.

In practice the position depends on the facts of each file:

• Was the premium actually reported as US wages? Many US returns for UK employees take total pay and benefits from the P60 and P11D and report the whole figure as wages. Where the premium was consistently included in US income year after year, there is a reasoned position that the benefit is attributable to after-tax contributions. IRS guidance has accepted that benefits are excludable where premiums under an employer plan were included in the employee's income.
• Was the premium left out of the US return? If earlier returns excluded the P11D value under section 106, the benefit is attributable to pre-tax employer contributions for US purposes and is taxable when received.
• Were the returns inconsistent? Some years in and some out produces an apportionment exercise, and Publication 525 describes a look-back approach for plans funded partly by each party.

This is a return-position question that has to be evidenced, with P11Ds, payslips and prior-year US returns on file. It is not something to resolve by instinct in either direction.

The four combinations compared

The table below sets out the general treatment of the four combinations that arise most often. It is a preparation aid, not a substitute for reading the policy and the payroll records.

Arrangement	UK: premium	UK: payout	US: premium	US: payout	What the returns show
Income protection paid personally from net income	No relief; paid from taxed income	Generally exempt	Paid with after-tax funds	Generally excluded under section 104(a)(3)	No income on either return; keep proof of premium payments
Employer-funded group income protection	Generally not a P11D benefit	Taxable as earnings through PAYE with National Insurance	Generally excluded under section 106	Generally taxable as compensation	Taxed in both countries; UK income tax available as a foreign tax credit
Critical illness cover paid personally	No relief; paid from taxed income	Lump sum generally tax free	Paid with after-tax funds	Generally excluded under section 104(a)(3)	No income on either return; the receiving account may still be reportable
Employer-paid critical illness cover	Generally a P11D benefit in kind	Lump sum generally tax free	Depends on whether the premium was includible and included in US wages	Potentially taxable unless the premium was in US income or section 105(c) applies	Possible US tax with no UK tax on the payout to credit

The fourth row is the one that causes real difficulty. A six-figure lump sum that the UK does not tax may be taxable in the US, and because the UK charged nothing on the payout there may be no foreign tax credit to set against it.

Are income protection payments foreign earned income for the FEIE?

The foreign earned income exclusion applies to wages, salaries, professional fees and other amounts received as compensation for personal services actually performed abroad. A benefit paid because the individual cannot perform services sits awkwardly within that definition.

Sick pay that continues through the employer's payroll under the contract of employment has the stronger claim to be treated as compensation connected with the employment. A benefit paid by an insurer under a policy, particularly after the employment has ended, is considerably harder to characterise as earned income. We do not treat the exclusion as available by default. For most senior UK-resident Americans the foreign tax credit is the more natural mechanism in any case, because UK income tax on employer-funded benefits is charged at rates that typically meet or exceed the US liability on the same income.

Which foreign tax credit basket applies?

Where an employer-funded income protection benefit is taxed through PAYE and is also US taxable, the UK income tax is generally creditable on Form 1116. The benefit is not interest, dividends, rents, royalties or another category of passive income, so it typically falls in the general category alongside salary. Three practical points follow:

• The credit is matched to the income it relates to. UK tax on the benefit sits in the same basket as the benefit, and cannot shelter passive income such as investment returns.
• Source has to be considered. Compensation is generally sourced where the services were performed, and a US citizen resident in the UK may need the treaty's relief from double taxation provisions where part of a benefit relates to US workdays.
• Where the UK exempts the payout and the US taxes it, there is no UK tax on that item at all. Excess credits carried forward in the general category from earlier years may be relevant, and should be checked before any tax is computed as payable.

The treaty does not otherwise change the answer. Its saving clause preserves the right of the United States to tax its citizens as if the treaty were not in force, subject to limited exceptions, so UK exemption of a benefit does not carry across to the US return.

Is a policy with no cash value reportable on the FBAR or Form 8938?

Generally not. The FBAR covers foreign financial accounts, a term that includes an insurance or annuity policy with a cash value. A pure protection policy that pays only on illness or incapacity and has no surrender value is not generally treated as a financial account. The same reasoning applies to Form 8938, which reaches cash-value insurance and annuity contracts issued by non-US insurers.

Three cautions apply in practice:

• The payout lands somewhere. A lump sum credited to a UK bank account raises that account's maximum balance for the year. The FBAR is required where the aggregate maximum value of foreign accounts exceeds $10,000 at any time in the year, and a large payout can push total assets over the Form 8938 thresholds, which for a single filer living abroad are $200,000 on the last day of the year or $300,000 at any time (double for joint filers).
• Check the policy really has no value. Some older or combined contracts carry an investment element or a surrender value. Those are reportable and may raise further US issues.
• Premiums paid to a non-US insurer. The US federal excise tax on premiums paid to foreign insurers is a separate question. In many UK cases treaty relief is relevant, and we confirm the position rather than assume it.

Our FBAR penalty calculator gives an indication of exposure where accounts receiving a payout were never reported.

What about partners and the self-employed?

A US partner in a UK partnership or LLP is not an employee, and sections 105 and 106 are written for employees. Where the partner pays for cover personally, with no UK deduction for the premiums, the result is generally aligned: benefits exempt in the UK and excluded in the US. Where the firm pays premiums on the partner's behalf, the cost is generally treated as part of the partner's profit share or drawings in the UK and as income to the partner in the US, which generally supports exclusion of the benefit. The partnership's records need to show how the premium was actually charged.

How the payout is reported on each return

The preparation sequence we follow is deliberately mechanical:

1. Obtain the policy schedule and claim letter. Identify the policyholder, the insured, the benefit type and whether any surrender value exists.
2. Reconstruct the premium history. Establish who paid, from which account, and whether any amount was salary sacrificed, payrolled or shown on a P11D.
3. Review the prior US returns. Determine whether employer-paid premiums were included in wages in each year of cover.
4. Classify the benefit under UK rules. Earnings through PAYE, exempt insurance benefit, or an apportioned mixture.
5. Classify the benefit under sections 104 and 105. Excluded, taxable, or apportioned, with the reasoning written down.
6. Translate and report. Taxable benefits are reported as wage-type income on Form 1040 even though no Form W-2 exists, translated into dollars on a consistent basis, with Form 1116 for the UK income tax deducted.
7. Update the information returns. Revisit the FBAR and Form 8938 for the year of receipt.

On the UK side, a benefit taxed through payroll flows into the employment pages from the P60 or P45; an exempt benefit is not entered as income. Our UK tax services and US tax services teams prepare the two returns together so that the same payout is not described in two inconsistent ways.

What if a payout was left off an earlier return?

The right route depends on what was omitted and why.

• A taxable benefit left off a filed US return. An amended return on Form 1040-X corrects the income, claims any foreign tax credit that was available, and settles the tax and interest. Where UK tax was paid on the same benefit, the additional US tax is often small or nil once the credit is applied.
• An exempt benefit reported as taxable. A refund claim is generally possible only within three years of filing the original return or two years of paying the tax, whichever is later, so older years should be reviewed promptly.
• No US returns filed at all. Americans abroad whose failure was non-wilful may be able to use the IRS streamlined procedures, which require three years of returns and six years of FBARs with a signed certification. Under the foreign offshore version, eligible non-resident filers pay the tax and interest without the usual failure-to-file and FBAR penalties. Our IRS streamlined filing team prepares these submissions as a single coordinated package.
• A UK error. A Self Assessment return can generally be amended within twelve months of the filing deadline, and an overpayment relief claim is generally available for up to four years from the end of the tax year. HMRC should also be told where an employer-funded benefit was paid without PAYE.

In every case the supporting file matters as much as the forms. A clear record of who paid each premium is what allows an exclusion to be sustained if the IRS asks.

Common errors we find in these files

• Assuming that UK tax-free status carries over to the US return.
• Assuming the opposite: reporting an individually funded benefit as US wages because it looked like income.
• Treating a P11D entry as proof that the premium was after-tax for US purposes without checking the US returns.
• Claiming the foreign earned income exclusion on insurer-paid benefits without analysis.
• Placing UK tax on a benefit in the wrong foreign tax credit category.
• Forgetting that a lump sum changes FBAR and Form 8938 figures for the year of receipt.
• Ignoring salary sacrifice, which affects whether any part of a group benefit counts as employee funded.

Speak to us in confidence

If you are a US citizen or green card holder in the UK who has received, or is about to receive, income protection benefits or a critical illness lump sum, the tax position should be established from the documents and reflected consistently on both returns. If a payout from an earlier year was never reported, it can be put right in an orderly way. Our US-UK tax accountants prepare both countries' returns and the related disclosures for senior executives, partners and founders. To have your policy, payroll records and prior returns reviewed, contact our cross-border team for a confidential consultation.