Tax Considerations – Individual Disability Premiums
When someone purchases individual disability insurance, premiums are generally not deductible for federal income tax purposes.
However, the rules vary when individual disabilitycoverage is purchased through an employer.
The rules discussed below apply to individual disability income policies as well as individual disability policies to replace lost retirement contributions.
Employer Sponsored Individual Disability Insurance Plans
Partnerships or S Corporations (IRS Revenue Ruling 91-26)
As per IRS Revenue Ruling 91-26, a partnership or S corporation may deduct Individual Disability premiums paid on behalf of a partner or 2% plus shareholder. Premiums must be included in the partner’s/shareholder’s personal taxable income. With this structure, benefits received would be tax free.
Executive Bonus (Section 162)
Under an executive bonus plan (“Section 162”), the employer pays the disability premium and the premium amount is treated as a “bonus.” The bonus is included in the employee’s personal taxable income and therefore the employer can deduct the premium amount. Policy benefits are received tax free, since the employee has purchased the policy with his or her bonus.
Qualified Sick Pay Plan (IRC Section 105)
Under a qualified sick pay plan, a C corporation can deduct premiums paid on owner-employees (stockholders who work in the business are considered to be employees). A formal plan must be adopted by the employer and communicated to covered employees. Premiums are not regarded as taxable income to the employees. However, benefits received under the plan are taxable. In addition, these benefits are also subject to Social Security tax for the first six months after the employee stops working.
Cafeteria Plan (Section 125)
In a cafeteria plan (“Section 125”), the employer an employee can elect to pay for individual disability premiums on a pre-tax basis and policy benefits are reported as taxable income to the employee.
Business Disability Products
Premiums for overhead expense policies are deductible by the business. This rule applies to unincorporated businesses, corporations and professional practices. Benefits received under the policy are taxable as income to the business. However, the benefits are used to pay business expenses which are generally tax-deductible.
Premiums are never deductible, regardless of who pays the premiums (the business or the owners). Benefits are paid tax-free to reimburse the purchase of a disabled owner’s business interest. The disabled owner is subject to taxation on any capital gain resulting from the sale of his or her ownership share. In a cross-purchase arrangement, the business can bonus the premium amount to the individual disability policy owner. That bonus is deductible to the business, but it must be included in the policy owner’s personal taxable income.
Key-Person Disability Insurance
If a business is designated to receive the benefits of a disability income policy insuring a “key person,” the premium is not deductible. The benefits received are tax-free for unincorporated businesses as well as corporations.
Because tax considerations are an integral part of sound business and personal planning, be sure to consult your tax advisor. This article is a general overview of the tax treatment of disability premiums and benefits for informational purposes only and it is not to be construed as tax or legal advice.