Disability Wage Continuation Plans

Disability Wage
Continuation Plans
in brief
Wage Continuation Plans
A Wage Continuation Plan is an employee accident or health plan which allows an
employer to continue a portion of a disabled employee’s wages.
Tax Advantages
• Employer Deduction - Employer payments with respect to a plan should be deductible as
reasonable compensation. Without a plan, the IRS may disallow a deduction.
• Employee Benefit - Employee taxed only on benefits that are paid on account of disability.
Employer payments to fund plan are not taxable to employee.
Participation
• Flexibility - A plan can benefit one or more employees. Different plans may exist for
different employees or classes of employees. See Treasury Regulation section (“Treas.
Reg. §”) 1.105-5(b).
• Employee Status - Only individuals classified as “employees” for fringe benefit purposes
may receive the tax advantages of a plan. The following are not considered “employees”
and will not receive the tax advantages of a plan:
- Sole proprietors, partners (including “members” of an LLC taxed as a partnership) and
more than 2% shareholders of S corporations. See Internal Revenue Code sections
(“IRC §”) 105(g), 401(c)(1) and 1372(a)(2);
- Other owners who are not employees; and
- Owner/employees benefiting only because of their status as owners. Larkin v. U.S.,
48 T.C. 629 (1967).
Establishing a Wage Continuation Plan
• Written Plan - It is recommended that the plan be written and announced to the employee
prior to disability.
• Corporate Resolution - As with any corporate action, it is recommended that a resolution
authorizing the employer’s action accompany the plan document.
• Funding Mechanism - The purchase of an Individual Disability Income policy is a costefficient way for an employer to fund the plan.
Alternatives in Structuring
Disability Income Arrangements (Personally Owned Policy)
Wage Continuation Plans
• Employer-Pay-All - Plan funded entirely by employer contributions.
• Contributory - Plan funded by both employer and employee contributions.
No Wage Continuation Plan
• Personally Paid - Employer is not involved with the payment of the policy premium.
• Bonus Arrangement - Employer pays a portion or all of the policy premium.
Tax Consequences of
Disability Income Arrangements
Premium
Benefit
Employer
Employee
Employer
Employee
Deductible
Not Taxable
*
Taxable
Employer-
Pay-All
Employer
Wage
Portion
Continuation Contributory
Deductible Not Taxable
*
Plan
Employer
Portion
Taxable
After-Tax
Not Taxable
Employee
Employee
Portion
Portion
No
Plan
Personally Paid
*
After-Tax
*
Not Taxable
Bonus
Deductible
Taxable
*
Not Taxable
*Employer not involved in transaction.
Tax Consequences of Disability Income Arrangements
Employer-Pay-All Plan
Premium: • Employer may deduct contributions to a plan to the extent they are reasonable compensation. IRC § 162(a).
• Employee may exclude employer contributions to the plan from income. IRC § 106.
• Employee does not have to pay Federal Insurance Contributions Act (“FICA”) or Federal Unemployment Tax Act (“FUTA”) taxes on employer contributions. IRC § § 3121(a)(2) and 3306(b)(2).
Benefit:
• Employer is not involved with the benefits paid at disability because they are paid directly to the insured by the insurance company.
• Employee must include benefits paid upon disability in income under IRC § 105(a), but may be eligible for an income tax credit under IRC § 22.
• Benefits are subject to FICA and FUTA taxes during the first 6 months of disability. IRC § § 3121(a)(4) and 3306(b)(4).
Contributory Plan
Premium: • Employer may deduct its portion of the premium to the extent it is reasonable compensation. IRC § 162(a).
• Employee portion of the premium is paid with after-tax dollars. Employer portion is excluded from employee’s income. IRC § 106.
• Employee does not have to pay FICA or FUTA taxes on employer contributions. IRC § § 3121(a)(2) and 3306(b)(2).
Benefit:
• Benefits attributable to employee contribution are exempt from FICA and FUTA taxes and those attributable to employer contribution are subject to FICA and FUTA taxes during the first 6 months of disability. IRC § § 3121(a)(4) and 3306(b)(4).
Personally Paid
Premium: • Premium is not deductible by the insured.
Benefit:
• Benefit is excluded from the insured’s income. IRC § 104(a)(3).
Bonus Arrangement
Premium: • Employer deducts the premium payment to the extent it is reasonable compensation. IRC § 162 (a).
• Employee includes the premium payment in income. IRC § 61.
Benefit:
• Employer is not involved with the benefits paid at disability because they are paid directly to the insured.
• Employee excludes the benefits paid upon disability from income. IRC § § 104(a)(3) and 105(a).
The Cost to Your Business of
Wage Continuation Alternatives
• You or one of your key employees becomes disabled.
• Your corporation is in a 30% (federal and state) tax bracket.
• You or one of your key employees is paid $5,000 per month while disabled.
1. 2. 3. 4. No Plan
Gross Income (1)
Corporate Tax
Corporate After-Tax Income
Disability Pay (2)
Net Income Remaining
$85,714
25,714
$60,000
60,000
$0
Self Funded Plan
Gross Income
Disability Pay (3)
Before-Tax Income
Corporate Tax
Net Income Remaining
$85,714
60,000
$25,714
7,714
$18,000
Plan with a Northwestern Mutual Policy
Gross Income
Disability Insurance Premiums (4)
Before-Tax Income
Corporate Tax
Net Income Remaining
$85,714
4,222
$81,492
24,447
$57,045
This is the annual income a corporation must generate to pay $5,000 per month for one year.
Disability payments are made after taxes with no plan.
Disability payments are made before taxes with a wage continuation plan.
Disability payments are made by Northwestern Mutual. The disability premium payments by the
employer will vary depending upon a number of factors, such as the number of insureds, ages, occupation
classifications, benefit amounts, and other policy provisions selected. The example assumes the disability
insurance premiums are paid by the employer on a 40 year old insured in the 5A occupation class, for a
non-cancellable and guaranteed renewable base definition policy with a 91 day Beginning Date and a To
Age 65 Benefit Period on a sex neutral, level/ARDI premium basis. The premium amount shown reflects 3
years of premiums paid prior to a disability. Includes volume and no tobacco use discount. The premium
reflects a deduction for dividends credited on the 2008 dividend scale. Dividends are based on claims,
expense and investment experience. The dividends assumed above are not guarantees or estimates of
future results.
This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements.
This information was compiled by the Advanced Planning Division of The Northwestern Mutual Life Insurance Company. It is
intended solely for the information and education of Northwestern Mutual Financial Network, its customers, and their own legal
or tax advisers. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any
penalties that may be imposed on a taxpayer. Northwestern Mutual and its Financial Representatives do not give legal or tax advice.
Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting, or tax adviser. Tax and
other planning developments after the original date of publication may affect these discussions.
—To comply with Circular 230 MDRT IR Index 2400.17
Copyright © 2008 by The Northwestern Mutual
Life Insurance Company, Milwaukee, WI
www.northwesternmutual.com
22-3892 (1194) (Rev 0608)