Key Person Disability Plans Tax
A key-person policy is paid for and owned by the business. An employer takes out a disability policy for a preset period on behalf of one or several irreplaceable employeesindividuals who are considered to be key persons in the companys operations. The business figures that it would suffer significant setbacks if its most valuable individual cannot work due to a disabling condition.
A company needs this compensation to cover staffing costs, project delays, profit loss, and maintain financial stability in the eyes of stakeholders. The employer pays the premium, which is not deductible, and benefits paid to the business are tax-free.
Life Insurance And S Corporations: Unique Rules Present Opportunity And Peril
Editor: Mindy Tyson Weber, CPA, M.Tax.
Life insurance on key employees and owners can be a powerful tool. It can generate tax-exempt proceeds that companies can use to help protect themselves against the death of key personnel while providing critical liquidity to the company if it must buy back shares from a deceased owner’s estate. This can be especially important for S corporations, which often have a unique interest in controlling the makeup of their shareholders to ensure continued qualification under Subchapter S.
However, life insurance policies, regardless of the type, present special considerations for S corporations. Those considerations and some of the related issues are outlined below.
Term Life Insurance
S corporation issues:The more interesting issues with term insurance relate to how the above rules affect various S corporation accounts. Again, the rules are relatively clear, but because they can affect a shareholder’s ability to access cash on a tax-free basis, they are important to understand.
Therefore, as long as these premiums are considered to be expenses related to tax-exempt income, they will not affect AAA. This is precisely what Rev. Rul. 2008-42 concludesthat premiums paid on corporate-owned life insurance do not reduce AAA, presumably based on a conclusion that those premiums are expenses related to income that would be nontaxable under Sec. 101.
Cash-Value Life Insurance
Business Structures And Disability Insurance Taxation
A businesss legal structure influences the taxation of any disability benefits received by the business owner or other employees. Most businesses that provide long-term disability insurance coverage to employees as a group benefit will treat the purchase of premiums for the LTD coverage as a tax-deductible expense. Below are general guidelines about how disability insurance taxes work under common business structures.
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Private Disability Policies Are Individual Disability Benefits Taxable
Disability benefits received from an individual disability policy you bought personally, with post-tax dollars, are not taxable.
However, the choice of paying for an individual policy with pre-tax vs. post-tax dollars is up to the policyholder. Using after-tax money is the preferred method, as you pay more now but have maximum funds available should you become disabled. If long-term disability becomes the reality, all taxes will have been paid.
If your premiums are paid with pre-tax dollars, you would need to pay taxes on your long-term disability benefits.
Will I Have To Pay Taxes On Disability Insurance Benefits
If you pay for your disability insurance premiums with after-tax income, you wonât be taxed again when you claim disability insurance benefits. Private insurance you buy outside of your employer is almost always paid with post-tax income.
For employer-sponsored plans, you could owe taxes when you claim disability insurance benefits if you or your employer paid your disability insurance premiums with pre-tax income. In this case, your benefits are categorized as income and the percentage of your premiums that you paid with pre-tax income would be reported as taxable income. Not all employers pay disability insurance premiums plans with pre-tax income, so you will want to check the details of your plan. If your plan does use pre-tax income, make sure to plan for smaller benefits. For example, a benefit thatâs supposed to be worth 80% of your income could end up being worth 70% or less after factoring in taxes.
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Special Rules For Taxing Certain Employee Fringe Benefits To 2% S Corporation Shareholders
Certain otherwise excludable fringe benefit items are required to be included as taxable wages when provided to a 2% shareholder of an S corporation. A 2% shareholder is any person who owns, directly or indirectly, on any day during the taxable year, more than 2% of the outstanding stock or stock possessing more than 2% of the total combined voting power of the corporation. These fringe benefits are generally excluded from the income of other employees but are taxable to 2% S corporation shareholders similar to partners. If these fringe benefits are not included in the shareholders Form W-2, they are not deductible for tax purposes by the S corporation. The disallowed deduction creates a mismatch of benefits and expenses among shareholders, with some shareholders paying more tax than if the fringe benefits had been properly reported on Form W-2.
Cafeteria plans: A 2% shareholder is not eligible to participate in a cafeteria plan created under IRC Section 125, nor can the shareholders spouse, child, grandchild or parent participate. If a 2% shareholder is allowed to participate in a cafeteria plan, the cafeteria plan will lose its tax-qualified status, and the benefits provided will, therefore, be taxable to all participating employees, nullifying any pretax salary reduction elections to obtain any benefits offered under the plan.
Nontaxable fringe benefits: The following fringe benefits are not includible in the compensation of 2% shareholders of an S corporation:
Fringe Benefits: Rules For 2% S Corporation Shareholders
Certain otherwise excludable fringe benefit items are required to be included as taxable wages when provided to a 2% S Corporation shareholder. A 2% shareholder is any person who owns directly or indirectly, on any day during the taxable year more than 2% of the outstanding stock or stock possessing more than 2% of the total combined voting power of the corporation.
These fringe benefits are generally excluded from the income of other employees but are taxable to 2% S corporation shareholders similar to partners. If these fringe benefits are not included in the shareholders Form W-2, they are not deductible for tax purposes by the S corporation. The disallowed deduction creates a mismatch of benefits and expenses among shareholders, with some shareholders paying more tax than if the fringe benefits had been properly reported on Form W-2.
Health, dental, vision, hospital and accident , and qualified long-term care insurance premiums
Premiums paid under a corporate plan are subject to FITW and SITW but not to FICA or FUTA. The amounts include premiums paid by the company on behalf of a 2% S corporation shareholder, as well as amounts reimbursed by the company for premiums paid directly by the shareholder. If the shareholder partially reimburses the S corporation for the premiums using post-tax payroll deductions, the net amount of premiums must be included in the shareholders compensation.
Short-term and long-term disability premiums
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How To Deduct Business Insurance Expenses
Costs you pay for most kinds of business insurance are deductible for tax purposes on your business income tax forms. Below is a look at the various types of business insurance and their deductibility and info where to deduct these business insurance expenses, depending on your business type and tax form.
Are Disability Insurance Premiums Tax
You cant deduct your disability insurance premiums from your personal taxes. You can deduct certain medical, dental, and long-term care insurance from your taxes, but life insurance and disability dont qualify for a deduction.
According to the IRS, you cant deduct premiums for the following policies:
- Coverage for loss of life, limbs, sight, etc.
- Policies that pay you while youre hospitalized for sickness or injury.
- Life insurance policies
- Coverage for loss of earnings
Essntially, all money is taxed at some point, whether its coming in or going out but it can only be taxed once. This means money thats initially taxed wont be taxed later. This applies to your disability premiums. Since its taxable money up front, if you become disabled and use the policy then the money you receive will be tax-free.
Does it matter if I have a short-term or long-term disability policy?
No. The tax implications are the same regardless of how long you collect on a disability policy.
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A Quick Review Of Long Term Disability Coverage
- Employer-sponsored group long-term disability plans. Group benefits cover all eligible employees and the employer typically pays all or part of the premiums as an employee benefit. This is the most common form of group LTD plan.
- Individual disability insurance policies. This is private coverage that a person purchases through an insurance agent. IDI is more efficient and costly because each policyholder is individually underwritten. The policyholder may buy additional coverage to ensure maximum coverage regarding his or her profession and income replacement goals.
- Professional associations may offer group disability insurance plans. Examples are AMA and ADA-sponsored policies available to physicians and dentists.
- You may opt for combined coverage, such as supplementing a group disability plan with an IDI policy.
Qualified Small Employer Health Reimbursement Arrangements For Eligible Small Employers
Under prior guidance, the IRS indicated that employers could not pay for the cost of individual health insurance for employees, or reimburse the premium cost for such individual policies, without violating ACA market reforms and triggering an excise tax of $100 per day per affected individual. With the passage of the 21st Century Cures Act in 2016, small employers can, beginning in 2017, establish Qualified Small Employer Health Reimbursement Arrangements . Described in IRC § 9831, a QSEHRA is an arrangement that a small business uses to reimburse its employees’ qualified medical expenses. The reimbursement is made after the employee incurs a medical expense and submits documentation. A QSEHRA cannot work in conjunction with a group health insurance plan. A QSEHRA will not violate the ACA coverage mandates if certain key requirements are met.
To establish a QSEHRA, the employer must:
- Be a small employer
- Not be subject to the Affordable Care Act’s employer shared responsibility provisions
- Not provide a group health plan to its employees and
- Be funded solely by the employer
All full-time employees must be eligible for the QSEHRA after a waiting period of no more than 90 days of service. There are certain permitted exclusions, such as for employees under age 25 and union employees. A QSEHRA may be funded only by the employer, not by employee salary reductions.
Under a QSEHRA, there is a maximum annual employer reimbursement, which is adjusted for inflation.
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Fewer Than Two Participants Who Are Current Employees Exception
As discussed above, market reforms do not apply to plans that cover fewer than two current employees. Notice 2015-17 explains that if the S corporation employs more than one employee, where the additional employee is a spouse or child of the shareholder and all employees are covered under a reimbursement arrangement with family coverage under the same plan, the arrangement would be considered to only cover one employee and would not be subject to the market reforms. Thus, an S corporation with only family employees covered by the same plan may continue to reimburse for a family plan and fall under the “fewer than two participants who are current employees” exception to the market reforms.
Do I Have To Report Disability Income On My Taxes
Yes, you will need to report disability income on your taxes in most situations. However, what you need to do depends on how much money you make and where the money is coming from.
Individual disability income insurance
The only time you dont have to report disability income on your taxes as an individual is if you make less than $25,000 a year, or less than $32,000 a year as a household.
These plans depend entirely on who is paying the premiums, and how.
- You pay. If you pay the premiums using after-tax dollars, then your benefits are tax-free and you wont have to report the income.
- Employer pays. If the employer pays for the entire policy and doesnt include this cost in your gross income, then the benefit is taxable and youll need to report the income on your taxes.
- Split pay. If you and your employer split the cost of the premiums, then the taxes are also split. You receive a portion of the benefit that you already paid for tax-free, but youll owe taxes on the part that was paid by your employer.
It also comes down to how you pay premiums. If you pay for the premiums with pre-tax money, then youll need to report the income on your taxes. If you pay for the premiums with after-tax income, then you dont need to report it. You can confirm with your employer if your disability plan was set up as pre-tax or after-tax.
Social Security benefits
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One Type Of Disability Insurance Premium That Is Tax
The closest you can come to deducting your disability insurance premiums is if you own a business.
For those who also have to be concerned with keeping their businesses running in the event of short-term or long-term disability, there is an option called business overhead expense insurance .
Whereas regular disability insurance covers individual income, a business overhead expense policy will help cover monthly business expenses such as employee salaries, rent, utilities, maintenance, taxes, etc.
Premiums for this type of insurance are considered a business expense and are therefore tax-deductible. Overhead expense policies are specifically listed in IRS Publication 535, Business Expenses. Under the heading of deductible premiums, the document states:
âOverhead insurance that pays for business overhead expenses you have during long periods of disability caused by your injury or sickness.â
Keep in mind, however, that deductibility does not apply to a business owner who gets disability insurance to cover lost personal income. It only applies to insurance that covers business expenses.
Fringe Benefits For More Than 2% Shareholders Of An S Corporation Benefit Minute
Generally, many fringe benefits provided to employees are excluded from taxable income. However, this favorable tax treatment is not available to an S corp shareholder who owns more than 2% of the stock of the corporation on any day of the corporations tax year . Section 1372 of the Internal Revenue Code requires that 2% shareholders be treated as partners in a partnership for this purpose, making them self-employed individuals instead of employees. This Benefit Minute summarizes how certain fringe benefits offered to 2% shareholders are treated.
Section 125 Cafeteria Plans/Health Savings Accounts
A cafeteria plan is a written plan established under Section 125 of the Code that allows an employee to choose between non-taxable benefits and taxable benefits . Employees can pay for qualified benefits on a pretax basis via salary reduction. It also allows for salary reduction for flexible spending accounts and health savings accounts . However, the tax benefit of salary reduction contributions is only available to employees. Since 2% shareholders are treated as self-employed individuals and not employees, they may not participate in a Section 125 cafeteria plan. This means they are ineligible to make pretax contributions for insurance, FSAs and/or HSAs. However, a 2% shareholder is permitted to contribute to an HSA on a post-tax basis and may be entitled to an above-the-line deduction on the Form 1040.
Group Term Life Insurance
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Is Disability Insurance Tax Deductible
Disability insurance is a critical part of any financial plan because it protects your ability to earn an income, which is one of your most valuable assets. If youâre injured or sick and canât work for several weeks or more, disability insurance will help you make up lost income. Itâs such a critical part of your financial plan because it allows you to keep paying for the essentials while also saving for future goals, such as retirement.
A frequent question about disability insurance is: Are disability insurance premiums tax deductible? In most cases, disability insurance premiums are not tax deductible â but thereâs more to this story. Hereâs a little more about how it works.
Disability Insurancepremiums Paid By A Business
Disability insurance costs paid by employers are deductible as salaries,wages and benefits, and are included as a taxable benefit on the T4 ofemployees. As mentioned above, insurance proceeds received by the employeein this case will be taxable to the employee.
If you are a self-employed sole proprietor, disability insurance costsfor yourself are nottax deductible, but if you make a claim on the insurance, the proceeds will notbe taxable. The same is true if you are an employee paying for your owndisability insurance plan because your employer doesn’t provide one.
The T2125Statement of Business or Professional Activities includes line 8690 forInsurance – this includes commercial insurance premiums for insurance on anybuildings, machinery and equipment you use in your business. See
It is always best totalk to your professional tax advisor regarding tax implications.
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Examples Of Tax Deductible Fringe Benefits
Fringe benefits are excellent ways that corporations can use to attract talent, provide security for its employees, and also enjoy the value that they receive by being able to deduct the costs of many of these benefits. Forms of tax-deductible fringe benefits that C corporations can offer their shareholders and employees include:
In many of these cases, the companys contribution to the plan is tax-deductible and is not included in the employees taxable income. However, in the case of Group Term Life Insurance only up to $50,000 can currently be deducted by the company and be considered non-taxable income for the employee. Payments received through disability insurance are treated as taxable income.