Part 6: Disability Insurance
Disability insurance covers two situations: loss of income owing to being disabled from an accident or illness and payments for the loss of a bodily function, a limb, or an organ.
Loss of a Bodily Function, a Limb, Payments made for the loss of a bodily function or a limb are tax-deductible for your company and tax-free for the employee.
Example: Juan works in a machine shop and loses an eye. The company provides disability benefits, paying $100,000 for the loss of a bodily function or an organ. The $100,000 that Juan receives is tax-free.
Disability Owing to Accident or Illness
Today, there’s a much better chance of being injured by accident or suffering a long term illness than dying. Sadly, when a catastrophe of this nature occurs, few would have the ability to continue their income if they could not work. This is the purpose of disability insurance.
Interestingly, companies have two options regarding disability premiums paid to an insurance company. The premiums can be either tax-free to the employee or taxable to the employee.
There’s a drawback to each option. If they’re tax-free to the employee, then the benefits would be taxable to the employee if he or she gets paid on the policy. However, if the employee gets taxed on the premiums or in fact pays the premiums, then the benefits are not taxable.
Example: Wise Corp. provides disability insurance on all its employees tax-free. Joan, an employee, becomes seriously injured in a car accident that keeps her out of work for six months. All payments to her will be fully taxable because the premiums were tax-free
IRS-Approved Tax-Planning Strategy
The IRS has ruled in a private ruling that an employee who had paid the total premiums for disability coverage in the policy year in which he suffered a disability and received payments would not be liable for taxes on those payments, even though his employer had paid the premiums in previous years. In other words, all disability payments that the employee received would be allowable to his payments and would not be taxable.
Isn’t this an amazing country?!
What this means to you is simple. Have your company deduct all premiums and treat them as tax-free to all the employees. However, in the year of a disability, have the company treat the premiums as taxable to the disabled employee; thus it will make the benefits tax-free.
Example: Joan is permanently injured in a car accident. If in the year of the injury she were taxed on the premiums paid by her employer, the benefits would seem to be tax-free.
As a final note, self-employed taxpayers or S-corporation shareholders who own more than 2 percent of the stock or partners are not employees. Thus a self-employed person cannot deduct disability insurance premiums. However, the benefits then would be tax-free.
The Bottom Line: All companies should provide for disability coverage and should both deduct the premiums and treat them as a tax-free benefit to the employee. If the benefit is for loss of a bodily function, the benefit is always tax-free. If the benefit is for loss of income owing to sickness or accident, treat the last year’s payment as income, and the benefits should become tax-free as well, not withstanding what was done in the prior years.
Sandy’s Note: This benefit has not been affected by the new tax laws. If you operate as an S corporation and own more than 2% of the stock, you would include these payments as income on your W-2 , but they are exempt from FICA taxes. This actually can be a benefit since if you collect disability payments from these policies, the payments are tax free since you were taxed on the premiums.
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