Chapter Nine

Taxes

 

 

General Tax Rules

 

In this chapter, we will describe, in genera1, the tax rules that currently apply to paying premiums for disability insurance and receiving benefits from disability policies. While many variables can affect the taxes of any one person, the goal of this chapter is only to provide you with the basic tax information you need to serve your clients. When clients want precise details about the impact of disability insurance purchases or benefit payments on their particular situations, they must consult legal or tax professionals. The information in this textbook does not represent legal or professional advice of any kind.

 

Policies Purchased by Individuals

 

When an Individual purchases and pays the premiums for an individual disability income insurance policy, the premium paid does not qualify for a tax deduction. Some people may be confused about this because DI insurance is considered a health or medical insurance coverage and some medical expense insurance premiums are tax deductible to the extent they meet percentage requirements specified in the tax code. Individually-paid DI insurance premiums are not deductible.

 

The advantage of non-deductible premiums, however, is that if the insured becomes disabled and receives disability income benefits, the benefits are not taxed as current income. They are received entirely income tax free.

 

Group Policies

 

With few exceptions today, premiums for group disability income insurance are paid for wholly or partially by the insureds-often the employees of a business group sponsor-in order to retain the tax-free receipt of benefits. Just as is true for individual policies, group DI benefits are free of taxation as long as the insured person pays the premiums. On the other hand, if the group sponsor pays the premiums. DI insurance benefits are taxed as current income when the insured receives them and the group sponsor may deduct the premiums as a business expense.

 

Sometimes the employer or other group sponsor shares the cost of group DI insurance premiums with the employee. This action gives the employer a tax deduction and the

 

 

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employee does not have to report as income the amount of the premium the employer paid on his or her behalf.

 

However, employer-paid premiums subject the insureds benefits to income taxation to the extent the employer paid the premium. For example, if the employer and the employee each pays 50% of the premium, 50% of any benefits paid are taxed as current income, while no taxes are assessed on the 50% attributable to employee-paid premiums.

 

Salary Continuation Funded by Insurance

 

While not all salary continuation plans are funded by insurance, when insurance funding is used and the plan has been formalized in writing, premiums paid by the employer are generally tax deductible as a business expense. However, with salary continuation plans, there is an exception to the general tax deductibility rule. Premiums paid for non-owner employees are deductible, but no deduction is permitted when premiums are paid for any employee who is also:

 

            *The working sole proprietor of the business.

            *A working partner/owner of the business.

            *A working owner of a Subchapter S corporation.

 

When premiums are paid by the employer for regular employees, the business normally takes a tax deduction. This means that the salary continuation parents made during the employee's disability are taxable income to the employee. And. because these are not considered true disability income benefits, the salary paid during disability is subject to all applicable federal income taxes, just as lithe employee were actively at work earning the income. Unfortunately, though, if the employer insures the plan and the proceeds are paid directly to the employer from the insurance company, the employer loses the tax deduction, so this arrangement is not preferred by employers.

 

To retain the tax benefits for the employer, a salary continuation plan may be set up so the insurance company pays benefits directly to the employee, rather than passing the funds through the employer. Alternately, the insurer may deposit the benefits into a trust, which then pays the funds directly to the employee, but the trust arrangement is rarely used today. In either case, the employee must eventually report the income on his or her tax return. However, the employee must pay two types of taxes for a short time while receiving the salary continuation benefits.

 

Social Security and federal unemployment tax IFUTA) withholding is required for the last calendar month the disabled person was working and for the six months of disability-a total of seven months-after which withholding is waived if the individual is still disabled. Figure 9-1 (on page 160) illustrates this withholding rule.

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Key Person DI

 

With key person insurance, there are neither tax advantages nor disadvantages to the key person personally, since any benefits are paid to the business. The business both pays the premiums and receives the benefits, but no tax deduction is permitted for premium payments. On the other hand, if benefits are paid to the business because the key person becomes disabled, the benefits are not taxed.

 

Executive Bonus DI

 

We'll remind you of how executive bonus plans work so you can understand the tax principles. The employer pays a bonus to the executive, who uses the bonus monies to purchase an individual disability income policy. The employer may deduct the bonus as a business expense.

 

The executive must pay current income taxes on the bonus and may not deduct the premium from taxes, as is the case with any other individual DI policy premium. However, any benefits paid to the executive because of disability are received tax-free.

 

Business Overhead Expense

 

The premiums for a business overhead expense (BOE) policy may be paid by the individual owners, who may be sole proprietors, partners or stockholders of a corporation, or by the business entity itself. In all cases, premiums are deductible as a business expense.

 

If DOE reimbursement benefits are paid to the business, the amount of benefits must be reported as taxable income. This income is, of course, offset by the business expense deduction the company is entitled to take.

 

Figure 9-1

Salary Continuation

Social Security and FUTA Withholding

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Disability Buyout

 

Premiums paid for an insurance policy that funds a disability buyout agreement are not tax deductible. Neither are the proceeds paid to the remaining owners taxable when the buyout is triggered. However, the disabled owner who is selling his or her interest under the agreement is probably subject to capital gains taxation. The exact tax consequences depend upon the type of business and the precise parties involved as we will describe shortly. First, let's briefly review the broad concept of capital gains taxes.

 

Capital gains refer to profits from the sale of capital assets such as real estate, stocks or a business. The capital gains tax advantage results from tax regulations that permit the taxpayer to deduct any capital losses from any capital gains for the year and report only the excess as income. This excess is then included in gross income and taxed at the individual's regular tax rates up to 28%. If you need more information about capital transactions and capital gains taxation before you continue this section, please consult a basic tax text.

 

Close Corporation

 

When the business is a close corporation and the buyout occurs between a disabled stockholder and either the corporation as an entity or the other stockholders, the buyout is treated as a capital transaction-the sale of a capital asset. This means the proceeds paid to the disabled stockholder are treated as a capital gain (or loss if that is the case) according to the Internal Revenue Code rules for such transactions.

 

Partnership Entity

 

When the business is a partnership, the tax rules differ depending on whether the purchasing party is an individual or the business entity. Let's first consider buyout by the partnership entity. In this case, the disabled partner's proceeds are taxed according to the rules for the liquidation-not sale-of a partner's interest. The primary difference between a liquidation and a sale (see the section following headed "Individual Partners") concerns the value of "goodwill," a somewhat vague term referring generally to the value of the reputation a business enjoys within the community and among competitors.

 

The taxing procedure can become complex in terms of valuing the partnership's goodwill and whether or not the value of goodwill had been stipulated in the buy-sell agreement. Typically, the value of a company's goodwill is treated as ordinary income unless the buy-sell agreement stipulates that goodwill is to be treated as capital. In the latter case, the value of the disabled partner's share of goodwill is subject to capital gains rules. The portion of the liquidated business interest that is not considered to be the value of goodwill is always treated as ordinary income.

 

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Individual Partners

 

If the buyout is between the individual partners, rather than between the disabled partner and the partnership entity, taxation occurs according to the rules for the sa1e-not liquidation-of a partner's interest. In this case, the entire transaction, including the value of goodwill, is considered a capital transaction. This means all proceeds are subject to capital gains taxation, with no option for the disabled partner to consider any part of the transaction as ordinary income.

 

Other Tax Rules

 

Constructive Receipt

 

When the disabled seller realizes a gain, rather than a loss, on the sale of the business interest, the gain as determined by capital gains regulations, is subject to current taxation In the year it is actually or constructively received. Constructive receipt refers to the time the individual first could have received the gain, whether or not it was actually received.

 

Because a business buyout involves a large sum of money, the disabled person might want to defer part of the buyout funds to another year in order to avoid a large tax hit. However, he or she cannot simply have a lump-sum insurance payment deposited somewhere and not draw on it all at once because this action would be considered constructive receipt and the gain would be taxed all at once. The disabled person may, however, have the funds deposited into a trust from which he or she receives installment payments. Since the trust is set up to make periodic payments only and the individual no longer has unlimited access to the full amount, the funds are no longer considered to have been constructively received. The disabled person now pays taxes only on the payments actually received from the trust as they are received.

 

Installment Sale

 

Some disability buyout policies pay benefits in installments instead of in a lump sum. In this case, the sale might qualify as an installment sale, subject to slightly different rules. Installment sales are taxed so that a certain part of each installment is considered a return of investment and part is considered a capital gain. Only the proportion treated as a capital gain is taxed each year as actually received.

 

Cash Value/Return of Premium Benefit

 

The cash value or return of premium feature included in some newer DI policies has not

 

 

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been addressed by any specific tax rulings as of this writing. It is assumed that the premium returns will be treated the same as dividends paid under participating cash value life insurance policies. If so, the transaction is considered to be a return of excess premiums to the insured and, therefore, not taxable income.

 

Tax Credit for Totally Disabled Individuals

 

A federal tax credit may be available to certain people who are totally disabled, but this credit is available only at very low-income levels. Eligibility for the credit requires the individual to meet a strict “any substantial gainful employment” definition of total and permanent disability.

 

We will not discuss this tax credit since people earning at the level described are not likely to be those you are interviewing for DI policy sales. The credit is mentioned here only so you can respond to prospects who might be aware that such a credit exists, but who are not informed about its severe limitations. The credit is sometimes referred to as a Section 22 credit, after the pertinent portion of the Internal Revenue Code.

 

Caution

 

The information provided in this chapter is limited to the highlights of disability income insurance taxation. Because tax laws are complex and must be considered in light of other factors that impact any individual's financial situation, people who want tax information specific to their personal circumstances must seek professional advice. While the information included in this chapter is correct as of the time the textbook was produced tax rules have always been and will continue to be subject to change.

 

Before you complete the review for this chapter, you can look over the table on page 165, which is a summary of the tax rules we've highlighted

 

 

 

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Disability Coverage Tax Highlights

 

Type of          Disability        Coverage	Tax Deduction for       Premiums         Paid	If   Deduction     Applies, Who Gets It	Premiums     Paid by     Others,    Taxed as      Income	Who              Receives            Benefits	Benefits      Taxed	Special Notes
Individual     DI Policy   Purchased by      Individual	No	N/A	N/A	Individual	No
Group DI	Yes, if      employer          pays.        No, if    employee pays.	Employer              N/A N/A	No            No              No Non	Individual      Employee	Yes, If  employer     pays.        No, if     Employee         pays.	If premiums shared by employer and employee, employee pays taxes on proportion of benefits paid by employer only.
Salary Continuation Funded by Insurance	Yes, except premiums paid for sole proprietors, partners, Sub S owners/ employees.	Employer	No	Individual Employee	Yes, and Usually subject to withholding	If insurer pays to trust or direct to Employee, employee may opt out of withholding except Social Security and FUTA withheld for 7 months.
Key Person                 DI	No	N/A	N/AN        N/A	Employer	No
Executive        Bonus DI	Yes	Employer	Bonus taxed   as income to            employee	Employee	No	Employee uses bonus to pay premium                                for individual DI policy.
Business    Overhead     Expense	Yes	Business	N/A	Business	Yes	Taxable benefit washed out by identical                   business expense deduction.
Disability                 Buyout	No	N/A	N/A	Business or              owner(s)	No	Disabled owner’s proceeds taxed as either capital gain or ordinary income, depending on circumstances.

 

 

 

 

 

Chapter 9 Review Questions

 

 

1.         It is generally preferable for an individual to pay his or her own premiums for a DI policy rather than have them paid by an employer because in this case (premiums are tax deductible/benefits are not taxed/both of the preceding are true).

 

 

 

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2.         An employer pays the premiums for a salary continuation plan funded by insurance. Premiums are deductible as a business expense when they are paid for (non-owner employees/all employees).

 

 

 

3.         A business may not take a tax deduction for disability insurance premiums when the policy provides (executive bonus plan funding/key person insurance/ BQE reimbursement/any of the preceding).

 

 

 

4.         In a disability buyout situation, capital gains taxation is an issue for the business partner or stockholder involved in (buying/selling/either buying or selling) the business interest.

 

 

5.         Under current tax rules, the cash value return of premium under this feature is (taxable Income/not taxed).

 

 

 

 

 

 

 

Answer

 

• benefits are not taxed
• non-owner employees
• key person insurance
• selling
• not taxed