Category: Compensation & Employee Benefits; Deductions
& Credits Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP), a C corporation, is a group of practicing physicians. TP wishes to purchase disability insurance for its shareholder/employees. TP has other full-time employees for whom no insurance coverage will be provided. The issue is whether the cost of the insurance coverage is excludable from the employee's income and deductible by the corporation. In general, employer provided disability insurance is excluded from employee income in the same way as employer provided health insurance benefits. Internal Revenue Code Section 106. Unlike health insurance benefits, however, disability benefits paid to the employee from such insurance are generally taxable to the employee unless the benefits are based on loss of bodily function as opposed to the employee's inability to earn income. In essence, normal disability benefits are taxable to the employee, but benefits which vary based on the type and severity of the employee's injury generally are not taxable to the employee. The exclusion of employer provided disability insurance coverage requires that such coverage be provided under a plan for the benefit of employees. There are two necessary elements: 1) there must be a plan, and 2) the plan must be for the benefit of employees. The plan requirement can be satisfied by an informal arrangement to provide coverage for employees. For tax purposes, the plan need not be written. Although this not a tax matter and is thus outside my area of qualification, it is my understanding that health and disability plans are subject to the provisions of the Employee Retirement Income Security Act (ERISA) which does require a written plan. This matter should be investigated thoroughly with a qualified attorney. The second element necessary for deductibility, the plan must be for employees, is potentially very troublesome in this case. It is necessary that the plan benefit employees, not just shareholders. If it can be demonstrated that the disability insurance benefits are provided because of shareholder status rather than employee status, both the excludability of the benefits to the employees and the deductibility of the benefits by the corporation can be attacked. Whether a plan is for employees or for shareholders is a question of fact. American Foundry v. Commr., 536 F2d 289 (9th Cir 1976), 76-1 USTC ¶9401, 37 AFTR2d 76-1373, revg on this issue 59 TC 231 (1972). It would seem to me very difficult, if not impossible, to successfully make the case that a plan that covers shareholder employees and excludes all other employees is providing coverage by virtue of employee status, not shareholder status. While there is no specific anti-discrimination provision for employer provided accident and health insurance benefits, the IRS has successfully attacked plans which provide benefits only to shareholders on the ground that the plan (if one was found to exist) was a plan for shareholders, not for employees. These cases held that the value of such coverage is a constructive dividend to the shareholder. See for example, John H. Kennedy, Inc. v. Commr., 36 TCM 878 and Larkin v. Commr., 68-1 USTC ¶9362. For C corporations, amounts paid by an employer to finance sickness and injury benefits for its employees generally constitute ordinary and necessary business expenses and are deductible under §162(a). S corporations are not allowed to deduct the cost of fringe benefits provided to more-than-2% shareholders. In addition, the exposure point discussed above regarding constructive dividend treatment of insurance coverage affects not only the excludability of the coverage from the employee's income but also the deductibility of the insurance coverage at the corporate level. If the value of the coverage were successfully recharacterized as a constructive dividend, the corporate deduction would be lost. |
