Business Owners: Avoid IRS’ IRC Section 105 penalties with a simple Qualified Sick-Pay Plan
Section 105 of the Internal Revenue Code allows for reimbursements of medical expenses under an employer-sponsored medical plan.
What would you do if one of your key
employees was disabled for a period of time?
Are you prepared for the serious problems
you may face should a key employee suffer
a serious illness or accident? An insured
disability salary continuation plan utilizing
individual disability income insurance can
help you answer these questions.
take a look at the advantages a disability
salary continuation plan has to offer:
• Both you and the employee are aware of the length
and amount of benefits a non-productive, disabled
employee would receive, eliminating a potential
• The amount of your financial obligation has
been established prior to the onset of an
• Disability criteria and qualifications for receiving
benefits are clearly defined. A third party, the
insurance company, determines the extent of the
disability, thus removing the burden from you.
• Any benefits paid to a disabled stockholder
employee should be considered wages (not a
dividend) by the IRS.
• Premiums are paid when all employees are actively
at work providing potential earning power.
• Benefits are paid when a key employee is disabled
and the potential earning power is low.
• Premium payments can be deductible as ordinary
and necessary business expenses by the employer.
Not only does a Disability Salary Continuation Plan offer
you a strategy to a potentially costly problem, it benefits
your employees, too.
With an insured disability salary continuation plan:
• Employees are protected against loss of income
due to disability.
• Only benefits paid during the first six months of
disability are subject to Social Security taxation.
• Financial obligations to the Plan remain constant,
regardless of the amount of disability benefits
that are paid.
“Pat and I began our architectural design firm
about 10 years ago. With a lot of hard work,
we’ve established our business among the
premiere design firms in the country. A key
to our success has been the ability to foster
and maintain relationships with clients. A
comprehensive benefits package that includes
a Disability Salary Continuation Plan has proven
to be an asset in the retention of our most
valuable employees. It gives us the competitive
edge in client relationships. And, in our
business, that’s what it’s all about.”
Patrick O. and Ian P.
Co-owners of an architectural design firm
COnsider the faCts.
COnsider the risks.
the risk of total disability is
greater than the risk of death
between ages 20 and 65.
You have options in funding a plan
Establishing a Disability Salary Continuation Plan
relieves your tax problem, but addressing the funding
and administration are also critical issues. Should you
retain all the financial risk of having to pay disability
benefits out of your firm’s assets, or should you
transfer most of that risk to an insurance company?
Most business owners choose to transfer all or some
of the liability for plan funding. The information
illustrated in the following chart may help you in
making your decision.
Just over one and four of today’s 20-year-olds will
become disabled before they retire.
Source: Social Security Administration, Fact Sheet March 18, 2011.
A 25-year-old worker who makes $50,000 a year and suffers a permanent disability could
lose $3,770,000 in future earnings to age 65 with a 3% annual salary increase.
here are examples of actual court
cases involving businesses that
failed to implement proper plans.
The Chism Ice Cream Company paid what it claimed
was disability salary continuation to a disabled
shareholder-employee for some five years before he
died. The Tax Court found that there was no plan and
noted the absence of anything detailed in writing. The
Tax Court decided the payments were not qualified
disability salary continuation benefits, but were, in the
eyes of the Court, classified as informal dividends. In
addition, the Company was not allowed the deduction
of payments to the executive. [Est. of E.W. Chism, TC
Memo 1962-6, aff’d 322 F.2d 956 (9th Cir. 1963)].
In the Chesapeake Manufacturing Company, Inc. v.
Commissioner case, there had been a history of
shareholder-employee withdrawals that were carried
on the books of the corporation as employee advances.
One of the shareholders was disabled. During this period
of disability, the company took a deduction for the
advances as compensation payments. However, the
Court felt that these amounts could not be considered
salary but were mere nondeductible “informal dividends.”
There was no showing that at any time the stockholders,
directors, or officers of Chesapeake established a
health, pension, or retirement plan. “In our opinion the
officer -stockholders in making the withdrawals here
in controversy took the money of Chesapeake for their
personal and permanent use and without thought or
intent at that time of making repayment to Chesapeake.
Consequently we have concluded and found as a fact
that the withdrawals in issue constituted informal
dividends to the officer-stockholders for the respective
years involved.” [Chesapeake Mfg. Co. Inc. v. Comm.,
TC Memo 1964-214, aff’d 347 F.2d 507 (4th Cir. 1965)].
These are only court case examples and are not to be construed
as legal or tax advice.
For more information about Disability Salary Continuation Plans,
consult your attorney. Your financial services representative
can provide more information and can assist you in obtaining
disability insurance to help meet your financial needs
versus emplOyee paid
As an employer, should I pay the premiums
for a disability salary continuation plan,
or should my employees pay the premiums
under a section 162 Bonus Agreement?