The taxability of sick pay depends upon whether the taxpayer paid the sick pay insurance premiums or the employer funded the sick pay.
Employee Funded Sick Pay – Where the employee pays the premiums on sick pay insurance, the sick pay is tax free and not subject to withholding or payroll taxes. In such cases, the sick pay is not included in W-2 Box 1 as taxable wages and instead is included in Box 12, Code J.
Employer Funded Sick Pay – Where the employer funds the sick pay, either by being self-insured or through a third party insurer, the sick pay is taxable to the employee and subject to payroll taxes.
Sick pay may be included in the employee’s regular W-2 or in a separate W-2 issued by the employer or by a third party payee (including an insurance company) using the third party’s EIN. Where the W-2 is issued by a third party, Box 13 will be checked “Third Party Sick-Pay”.
In some cases Box 13 will be checked and Box 12 will be coded J, meaning the third party payment is not taxable, in which case Box 1 of the W-2 should be blank.
Form W-4S – Where the sick pay is paid by a third party payee that handles the payroll taxes, withholding, and reporting separately from the employer, Form W-4S must be filed with the third party by the employee in order to have tax withheld.
Railroad Sick Pay - Payments received as sick pay under the Railroad Unemployment Insurance Act are taxable and must be included in income. However, they are not included if they’re for an on-the-job injury.