Category: Compensation & Employee Benefits; Deductions
& Credits; Corporations; Individuals Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer(TP) is a C corporation. TP's shareholders are its only employees at present. TP wishes to purchase disability insurance for the employees. 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. Sec 106. Unlike health insurance benefits, 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 coverage requires that such coverage be provided under a plan for the benefit of employees. There are two necessary elements, there must be a plan, and 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 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. While there is no specific anti-discrimination provision for employer provided accident and health insurance benefits, the IRS has attacked plans which provide benefits only to shareholders contending 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. At this moment of course, the corporation's only employees are shareholders. In order to avoid constructive dividend status, two things can be done at this time. First, the plan should be arranged so that the level of coverage does not correlate in any way with the employee's stock holdings or status as a stockholder. It is essential that the amount of coverage not be proportional to stock ownership. Second, the plan should provide for coverage of any future employees that may be hired. Without that second element, it seems to me that it cannot be demonstrated that the plan is for the benefit of employees as opposed to shareholders.
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