PRINT - Chapter 7

<body topmargin=0 leftmargin=0 marginheight=0 marginwidth=0> <table cellpadding=0 cellspacing=0 border=0><tr> <td valign="top" colspan=2 height=90 BGCOLOR="#006699" TEXT="#080000" bgproperties="fixed" background="122285a1erlcgo.gif"> <div> <FONT SIZE="5" COLOR="#FFCC66" FACE="Arial" ><B>Disability Income Insurance</B></FONT><B>     |     </B><A HREF="index.htm" TARGET="_top" TITLE="Disability Income Insurance"><U><B>home</B></U></A><B>           </B><A HREF="id16.htm" TARGET="_top" TITLE="TABLE OF CONTENTS"><U>TABLE OF CONTENTS</U></A>   |   <A HREF="id17.htm" TARGET="_top" TITLE="GLOSSARY"><U>GLOSSARY</U></A>   |   <A HREF="id66.htm" TARGET="_top" TITLE="Print Version"><U>Print Version</U></A>   |   <A HREF="id64.htm" TARGET="_top" TITLE="Review Questions"><U>Review Questions</U></A>   |   <A HREF="id18.htm" TARGET="_top" TITLE="FINAL EXAM"><U>FINAL EXAM</U></A></div> <div> <A HREF="id57.htm" TARGET="_top" TITLE="PRINT Chapter 1"><U>PRINT - Chapter 1</U></A>   |   <A HREF="id58.htm" TARGET="_top" TITLE="PRINT Chapter 2"><U>PRINT - Chapter 2</U></A>   |   <A HREF="id59.htm" TARGET="_top" TITLE="PRINT Chapter 3"><U>PRINT - Chapter 3</U></A>   |   <A HREF="id60.htm" TARGET="_top" TITLE="PRINT Chapter 4"><U>PRINT - Chapter 4</U></A>   |   <A HREF="id61.htm" TARGET="_top" TITLE="PRINT Chapter 5"><U>PRINT - Chapter 5</U></A>   |   <A HREF="id62.htm" TARGET="_top" TITLE="PRINT Chapter 6"><U>PRINT - Chapter 6</U></A>   |   <B>PRINT - Chapter 7</B></div> <div> </div> </td> </tr><tr> <td valign="top" width=210 BGCOLOR="#FFCC66" TEXT="#080000" background="121d2c00dkelyh.gif"> <div> <A HREF="mailto:instructor@wallstreetinstructors.com" TARGET="_top" TITLE="mailto:instructor@wallstreetinstructors."><U><IMG SRC="12baf630.gif" border=0 width="175" height="99" ALIGN="BOTTOM" HSPACE="0" VSPACE="0"></U></A></div> <div> <TABLE BORDER="2" CELLPADDING="2" CELLSPACING="1" WIDTH="83" BORDERCOLORLIGHT="#C0C0C0" BORDERCOLORDARK="#808080" FRAME="BOX" RULES="ALL" ALIGN="BOTTOM" HSPACE="0" VSPACE="0" > <tR> <tD VALIGN=TOP HEIGHT= 16 ><NOBR><div> <A HREF="mailto:instructor@wallstreetinstructors.com" TARGET="_top" TITLE="mailto:instructor@wallstreetinstructors."><U>Instructor</U></A></div> </NOBR></tD> </tR> </TABLE></div> <div>  </div> <bR> <div> Copyright <FONT SIZE="2" COLOR="#000080" FACE="Arial" >©2004</FONT> Wall Street Instructors, Inc. All rights reserved. No portion of this publication may be reproduced, stored in a retrieval system, or transmitted in any form by any means electronic, mechanical, photocopying, recording or otherwise without prior written permission of Wall Street Instructors, Inc.</div> <bR> </td> <td valign="top" height=390 BGCOLOR="#FFFFFF" TEXT="#080000"> <div> <I>PRINT - Chapter 7</I></div> <div> <B>Taxation of Disability Coverage</B></div> <bR> <bR> <div> The important points addressed in this lesson are:</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">The general rule concerning the tax treatment of disability income insurance premiums and benefits is that if the premium is non-deductible the benefits are tax-free; if the premium is deductible, the benefits are taxable</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Disability income insurance premiums paid by an employer on an employee-owned policy are generally tax deductible and non-taxable to employees</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Disability income insurance premiums paid by an employer on a policy owned by the employer are not tax deductible, but benefits are received tax free</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Disability income insurance premiums paid by an employer on a policy owned by the sole proprietor, partner or more-than-2% S corporation owner are not deductible by the business </div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Disability income insurance premiums paid by a regular corporation on a policy owned by an employee-stockholder are tax deductible, regardless of the extent of the employee's corporate ownership</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Disability Overhead Expense policy premiums are tax deductible to the premium payor, regardless of the type of organization</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Although Disability Overhead Expense benefits are taxable when received, their reimbursement of deductible expenses results in a tax wash</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Disability buyout and keyperson policy premiums are not deductible to the premium payor</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Disability buyout and keyperson benefits are tax free when received</div> <bR> <bR> <div> <I><B>Introduction</B></I></div> <bR> <div> There is a general rule that applies to the income tax treatment of disability insurance, and it is a fundamentally fair one. The general rule is that if deduction of the premium is not allowed, the benefit is received income tax-free -- and vice versa.  In the case of individually purchased disability income policies, the premium is non-deductible.  As a result, the monthly income benefit is received entirely tax-free.  </div> <bR> <div> When we consider disability income insurance taxation, we need to focus on the entity that is paying the premiums for the disability insurance policy.  </div> <bR> <bR> <div> <I><B>Disability Income Policies</B></I></div> <bR> <div> <B>Individually-Purchased Policies</B></div> <bR> <div> As we noted, if the policyowner pays the premiums, no deduction is permitted for premiums, but benefits are tax-free.  There are situations, however, in which premiums paid for individual disability income policies are<I> </I>income tax deductible.  Generally, these are situations in which an employer pays the premiums.</div> <bR> <bR> <div> <B>Employer-Paid Policies</B></div> <bR> <div> It is not unusual for an employer to purchase one or more individual disability income policies on key executives with benefits payable directly to the executives in the event of their disability.  We briefly discussed this arrangement earlier in the course and referred to it as a sick pay plan in which the insureds own the policies on which the employer pays the premiums.  In such a case, the premiums will usually be income tax deductible to the employer and are not taxable to the employees.  When received by the executives, benefits are includible in income.</div> <bR> <div> Although employer payment of disability income premiums on policies owned by employees usually results in a tax deduction, this is not always the case.  In certain situations, the employer-paid premium for these policies owned by the insureds would not be deductible.  The principal reason for the lack of deductibility is the ownership of the employer by the employee.</div> <bR> <div> When an employer pays disability income insurance premiums for insureds who are also sole proprietors, partners or more-than-2% S corporation shareholders of the employer, the premiums are not tax deductible even though benefits would be paid directly to the insureds. In this case, however, the benefits are income tax free when received by the employees. </div> <bR> <div> Disability income insurance premiums paid for non-owner employees of sole proprietorships, partnerships or S corporations are tax deductible.  As you can see, it is not the <I>type</I> of employer that makes the employer's payment of disability income premiums deductible or not, it is the relationship of the insured employee to these employers that is controlling.  </div> <bR> <div> In the case of each of these organizations, the business income and losses flow through to the individual business owner, i.e. the business is not a separate tax entity from its owners.  So, to permit these businesses to pay and deduct disability income premiums on policies owned by the business owners would be to enable them to do indirectly what they are prohibited from doing directly: deduct premiums on personally-owned disability income insurance.  </div> <bR> <div> Employer-paid disability income insurance premiums on policies owned by shareholder-employees of regular corporations -- corporations that have not taken the S election -- are treated much more favorably.  Disability income insurance premiums paid by regular corporations are deductible regardless of the extent of the employee's ownership in the corporation.  </div> <bR> <div> The difference in the tax treatment lies in the fact that the regular corporation and its owner are separate tax entities.</div> <bR> <div> Sometimes, a corporation that establishes a sick pay plan will choose to own the disability income policies and have disability benefits paid to it rather than to the individual employees.  Policies arranged in this way -- with the employer being premium payer, owner and beneficiary -- are taxed as follows:</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Premiums are not deductible to the employer</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Benefits are received tax-free by the employer</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Benefits are deductible to the employer when paid to the employee</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700f000000000.gif" HEIGHT="16" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Benefits are taxable to the employee when received</div> <bR> <div> Although the possible employer tax deduction is much larger if the employer receives the benefit and then pays it to the disabled employee, many employers will choose to make the benefits payable directly to the employee in order to obtain the guarantee of tax deductible premiums.  The rationale seems to be that a smaller guaranteed tax benefit is more desirable than a larger tax benefit that may not be obtained.</div> <bR> <bR> <div> <I><B>Business-Related Disability Coverage</B></I></div> <bR> <div> <B>Overhead Expense Policies</B></div> <bR> <div> The tax treatment that is afforded certain specialty disability policies is not entirely consistent with the tax treatment given to disability income insurance policies.  This difference is readily apparent in Overhead Expense policies.  </div> <bR> <div> The premiums paid for overhead expense policies are tax deductible, regardless of the type of organization that pays them.  The sole proprietorship, partnership and corporation all enjoy the tax-deductibility of Overhead Expense policy premiums.  </div> <bR> <div> Consistent with the general rule concerning disability insurance taxation, the Overhead Expense benefits are considered taxable income when they are received.  However, because Overhead Expense benefits are reimbursement benefits that are received for tax-deductible business expenses that have already been paid by the policyowner, the net tax treatment is a wash.  While the benefits are taxable, the paid expenses are deductible.</div> <bR> <bR> <div> <B>Disability Buyout & Keyperson Policies</B></div> <bR> <div> In the case of disability buyout and keyperson disability policies, the premium payor and the beneficiary are the same entity.  As a result, they share the same tax treatment given to personally owned disability income insurance policies.  Both disability buyout policies and key person disability policies enjoy tax-free benefits, but the premiums are paid with after-tax dollars.  Since the business is both premium payor and beneficiary of these policies, the tax treatment necessarily follows.</div> <bR> <bR> <div> <I><B>Summary</B></I></div> <bR> <div> Income taxation rules with respect to disability income insurance generally provide that premiums are not deductible, but benefits are received tax-free.  An exception to the rule concerning non-deductibility of disability income insurance premiums applies to policy premiums paid by an employer on a policy owned by the employee.  In such a case, the premiums are generally tax deductible to the employer and non-taxable to the employee.  When received, however, benefits are taxable to the employee.</div> <bR> <div> Disability Overhead Expense policy premiums are tax deductible to the premium payor.  Benefits, however, are taxable.  Disability Keyperson and Buyout policy premiums are not deductible to premium payors, but benefits are received tax-free.  </div> <bR> </td> </tr></table></body>