Tax Status of Disability Income Policies

Individually-Purchased Policies

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 income tax deductible.  Generally, these are situations in which an employer pays the premiums.

 Employer-Paid Policies

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.

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.

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.

 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 type 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.  

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.  

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.  

The difference in the tax treatment lies in the fact that the regular corporation and its owner are separate tax entities.

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:

Premiums are not deductible to the employer
Benefits are received tax-free by the employer
Benefits are deductible to the employer when paid to the employee
Benefits are taxable to the employee when received

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.