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Disability Income Coverage

  • 377. What are the tax consequences when a corporation buys disability insurance on a key person under which benefits are paid to the corporation?

    • A corporation cannot deduct premiums it pays but can exclude insurance benefits from its gross income.1 Disability income, regardless of amount, is wholly tax-exempt to the corporation under IRC Section 104(a)(3).2 Because the disability income is tax-exempt, a deduction for premiums is disallowable under IRC Section 265(a)(1) on the ground that the premiums are expenses paid to acquire tax-exempt income.3 An accidental death benefit may be tax-exempt to a corporation under IRC Section 101(a) as death proceeds of life insurance (Q 63). Premiums paid for tax-exempt accidental death coverage are nondeductible under IRC Section 264(a)(1) (Q 262).

      On January 16, 2009, the Office of Associate Chief Counsel (Income Tax & Accounting) issued Chief Counsel Advice4 concluding that a taxpayer may not take a deduction under Section 162 for compensation paid to an employee pursuant to an employment contract, because the taxpayer was receiving disability insurance payments on account of the employee’s injury and Section 162 disallows a deduction for an expense for which there is a right or expectation of reimbursement.

      However, upon further consideration, the Office of Associate Chief Counsel (Income Tax & Accounting) concluded, based upon the facts in the prior CCA, that a taxpayer is not precluded from taking a Section 162 deduction for compensation paid to an employee pursuant to the employment contract merely because the taxpayer received insurance payments on account of an employee’s disability. Nor does Section 265(a)(1) disallow such a deduction.5


      1.    Rev. Rul. 66-262, 1966-2 CB 105.

      2.    Castner Garage, Ltd. v. Comm., 43 BTA 1 (1940).

      3.    Rugby Prod. Ltd. v. Comm., 100 TC 531 (1993).

      4.    CCA POSTF-135262-08.

      5.    IRS Office of Chief Counsel Memorandum No. 200947035, Nov. 20, 2009.

  • 378. Are premiums paid for business overhead expense disability insurance deductible as a business expense?

    • Yes. The IRS has ruled that premiums paid on an overhead expense disability policy, a special type of contract that reimburses professionals or owner-operators for overhead expenses actually incurred during periods of disability, are deductible as a business expense and the proceeds are taxable.1 The ruling relates to self-employed individuals.

      Premiums paid on standard personal disability insurance are not deductible as a business expense but the proceeds are tax-exempt as compensation for personal injuries or sickness (Q 382).2 This is true even though a taxpayer intends to use the benefits to pay overhead expenses during periods of disability.3 (See Q 377.)


      1.    Rev. Rul. 55-264, 1955-1 CB 11.

      2.    Rev. Rul. 55-331, 1955-1 CB 271; Rev. Rul. 70-394, 1970-2 CB 34.

      3.    Rev. Rul. 58-480, 1958-2 CB 62; Blaess v. Comm., 28 TC 710 (1957); Andrews v. Comm., TC Memo 1970-32.

  • 379. What are the tax consequences when disability insurance is purchased on the lives of business owners to fund a disability buy-out?

    • Whether a purchaser, policyowner, beneficiary, or premium payor is the business entity, as in an entity purchase agreement, or the business owner, as in a cross-purchase agreement, the premiums are nondeductible and the proceeds are exempt from regularly calculated income tax (Q 377).1

      Where a buy-out occurs between a corporation and a disabled shareholder, if the transaction qualifies as a complete redemption of all the shareholder’s shares, the redemption will be treated as a capital transaction (Q 300). That is, the transaction will be considered the sale of a capital asset and the selling shareholder’s gain or loss will be measured and taxed. A disability buy-out between shareholders also is a capital transaction and is taxed accordingly.2

      Where a buy-out occurs between a partnership and a disabled partner, resulting in a termination of the disabled partner’s interest, the transaction is taxed under the rules applying to a liquidation of a partner’s interest (Q 311).

      Where a buy-out occurs between partners, the transaction is taxed under the rules applying to a sale of a partner’s interest (Q 311).

      When a disabled business owner realizes gain on the sale of his or her business interest, the amount of gain is includable in his or her gross income in the taxable year in which the gain is actually or constructively received unless the gain is includable in a different year due to the taxpayer’s method of accounting.3 If a sale qualifies as an installment sale, a pro rata portion of the gain is reportable for each taxable year installment payments are received.


      1.    IRC §§ 104(a)(3), 265(a)(1); Rev. Rul. 66-262, 1966-2 CB 105.

      2.    IRC §§ 61(a)(3), 1001, 1011, 1221, and 1222.

      3.    Treas. Reg. § 1.451-1(a).

  • 380. Can an employer deduct premiums paid for employer-provided disability income coverage?

    • An employer generally can deduct all premiums paid for disability income coverage for one or more employees as a business expense.

      Premiums are deductible by an employer whether coverage is provided under a group policy or under individual policies. The deduction is allowable only if benefits are payable to employees or their beneficiaries; it is not allowable if benefits are payable to an employer.1

      The deduction of premiums paid for a disability income policy insuring an employee-shareholder was prohibited where the corporation was the premium payor, owner, and beneficiary of the policy. The Tax Court held that IRC Section 265(a) prevented the deduction because the premiums were funds expended to produce tax-exempt income. The Tax Court stated that disability income policy benefits, had any been paid, would have been tax-exempt under IRC Section 104(a)(3).2


      1.    Treas. Reg. § 1.162-10(a); Rev. Rul. 58-90, 1958-1 CB 88; Rev. Rul. 56-632, 1956-2 CB 101.

      2.    Rugby Prod. Ltd. v. Comm., 100 TC 531 (1993). See Rev. Rul. 66-262, 1966-2 CB 105.

  • 381. How are benefits provided under an employer-provided disability income plan taxed?

    • Sick pay, wage continuation payments, and disability income payments, both preretirement and postretirement, generally are fully includable in gross income and taxable to an employee.1 Specifically, long-term disability income payments received under a policy paid for by an employer are fully includable in income to a taxpayer.2

      A disabled former employee could not exclude from income a lump sum payment received from the insurance company that provided the employee’s employer-paid long-term disability coverage. The lump sum nature of the settlement did not change the nature of the payment into something other than a payment received under accident or health insurance.3

      If benefits are received under a plan to which an employee has contributed, the portion of the disability income attributable to the employee’s contributions is tax-free.4 Under an individual policy, an employee’s contributions for the current policy year are taken into consideration. With a group policy, an employee’s contributions for the last three years, if known, are considered.5

      In Revenue Ruling 2004-55, the IRS held that the three-year look back rule did not apply because the plan was amended so that, with respect to each employee, the amended plan was financed either solely by the employer or solely by the employee. The three-year look back rule does not apply if a plan is not considered a contributory plan.

      An employer may allow employees to elect, on an annual basis, whether to have premiums for a group disability income policy included in employees’ income for that year. An employee who elects to have premiums included in his or her income will not be taxed on benefits received during a period of disability beginning in that tax year.6 An employee’s election will be effective for each tax year without regard to employer and employee contributions for prior years.

      Where an employee-owner reimbursed his corporation for payment of premiums on a disability income policy, the benefit payments that he received while disabled were excludable from income under IRC Section 104(a)(3).7

      Where an employer initially paid disability income insurance premiums but, prior to a second period of benefit payments, an employee took responsibility for paying premiums personally, the benefits paid from the disability income policy during the second benefit-paying period were not includable in the employee’s income.8

      Premiums paid by a former employee under an earlier long-term disability plan were not considered paid toward a later plan from which the employee received benefit payments. Thus, disability benefits were includable in income.9 If an employer merely withholds employee contributions and makes none itself, the payments are excludable.10 A tax credit for disability retirement income is available to taxpayers receiving those payments after the minimum age at which they would have received a pension or annuity if not disabled. This credit is called the Disability and Earned Income Tax Credit (EITC).


      1.    Let. Ruls. 9103043, 9036049.

      2.    Cash v. Comm., TC Memo 1994-166; Rabideau v. Comm., TC Memo 1997-230. See also Pearson v. Comm., TC Memo 2000-160; Crandall v. Comm., TC Memo 1996-463.

      3.    Kees v. Comm., TC Memo 1999-41.

      4.    Treas. Reg. § 1.105-1(c).

      5.    Treas. Reg. § 1.105-1(d).

      6.    Rev. Rul. 2004-55, 2004-26 IRB 1081.

      7.    Bouquett v. Comm., 67 TCM 2959 (1994).

      8.    Let. Rul. 9741035. See also Let. Rul. 200019005.

      9.    Chernik v. Comm., TC Memo 1999-313.

      10.    Rev. Rul. 73-347, 1973-2 CB 25.

  • 382. Are premiums paid for personal disability income coverage tax deductible?

    • Premiums for non-medical care, such as personal disability income coverage, are not deductible.1 Only premiums for medical care insurance are deductible as a medical expense (Q 342, Q 487).

      A deduction is allowed for medical care that is not otherwise compensated for by insurance. The deduction is allowed to the extent that the medical care expenses exceed 7.5 percent of the taxpayer’s adjusted gross income. The 10 percent limit was permanently reduced to 7.5 percent in 2020. The threshold is 7.5 percent for the alternative minimum tax.


      1.    See IRC § 213(d)(1).

  • 383. How are benefits provided under a personal disability income coverage plan taxed?

    • Benefits from personal disability income coverage typically are entirely exempt from income tax. There is no limit on the amount of benefits, including the amount of disability income that can be received tax-free under personally paid disability income coverage.1

      If benefits are received under a plan to which both an employer and employee have contributed, the portion of the disability income attributable to the employee’s contributions is tax-free (Q 380).2


      1.    IRC § 104(a)(3); Rev. Rul. 55-331, 1955-1 CB 271, modified by Rev. Rul. 68-212, 1968-1 CB 91; Rev. Rul. 70-394, 1970-2 CB 34.

      2.    Treas. Reg. § 1.105-1(c).

  • 384. How are disability pension payments taxed to common law employees made from a qualified pension or profit-sharing plan?

    • Disability payments from a qualified plan receive different tax treatment, depending on whether the payments are made to common law employees or to self-employed individuals (see Q 385).

      If a disability pension is derived from employer contributions and is made in lieu of wages to an employee who retired on account of permanent and total disability, the employee may be entitled to an Earned Income Tax Credit (EITC) (Q 380). The employee is not entitled to exclude from income any part of a disability benefit derived from employer contributions.

      In a contributory plan, it will be presumed that a disability pension is derived from employer contributions unless the plan expressly provides otherwise.

      Under IRC Section 72(d), amounts received from disability pensions can be excluded from income until an employee has excluded an amount that is equal to his or her consideration for the contract. Under the three-year rule, if the total amounts received by the employee during the first three years that payments are made on the contract either equal or exceed the consideration paid by the employee, then the payments will be excluded from the employee’s income until the amount of consideration has been met. Any employee contributions that were allocated to provide disability payments cannot be included in the employee’s cost basis in figuring the tax on his or her retirement pension payments.1

      In the case of a plan that required employees to pay premiums for their disability coverage, subject to a right of reimbursement from their employer, the Tax Court determined that disability payments for a six month period where an employee was on leave without sick pay were includable in the employee’s income. The Tax Court held that the employees were required to pay taxes on the recovered past-due benefits they received because there were no actual repayments made.2

      The payment of post-retirement medical expense benefits is tax-free to an employee.3

      A few courts have held that a profit sharing plan also can be an accident or health plan so that payment of the full amount in the employee’s account on termination of employment because of permanent disability for loss of a bodily function is entirely excludable under IRC Section 105(c).4 Absent clear evidence to the contrary, other courts have been reluctant to find deferred compensation profit sharing plans to be dual purpose plans intended to provide both retirement and health or accident benefits.5 Distributions from these plans have been held to be taxable because they were not computed in reference to a taxpayer’s disability, that is, in an accident or health plan, but were instead computed in reference to the taxpayer’s length of service.6

      An individual who terminated employment on account of disability after the normal retirement date but prior to a deferred retirement date could not claim the IRC Section 105(c) exclusion because the plan provided that payments after normal retirement age would be paid on account of age and years of service rather than on account of injury or sickness.7

      The IRS has taken the position that distributions made from a qualified profit-sharing trust, when used to pay for an employee’s medical-care expenses, cannot be excluded from income as accident or health benefits under Section 105(b). Instead, the distributions must be included in employee income as previously earned deferred compensation under Section 402(a).8


      1.    Treas. Reg. § 1.72-15(c); Butler v. Comm., TC Memo 1987-463.

      2.    Andrews v. Comm., TC Memo 1992-668.

      3.    Treas. Reg. § 1.72-15(h), Treas. Reg. § 1.402(a)-1(e)(2).

      4.    Wood v. U.S., 590 F.2d 321 (9th Cir. 1979); Masterson v. U.S., 478 F. Supp. 454, 79-2 USTC 9664 (N.D. Ill. 1979); Berner v. U.S., 81-2 USTC 9733 (W.D. Pa. 1981).

      5.    Caplin v. U.S., 718 F.2d 544 (2d Cir. 1983); Berman v. Comm., 925 F.2d 936 (6th Cir. 1991); Gordon v. Comm., 88 TC 630 (1987); Paul v. U.S., 682 F. Supp. 329 (E.D. Mich. 1988).

      6.    Est. of Hall v. Comm., 103 F. 3d 112, 97-1 USTC 50,104 (3d Cir. 1996); Dorroh v. Comm., 74 F.3d 1255, 96-1 USTC 50,119 (11th Cir. 1996); see also Let. Rul. 8824013.

      7.    Let. Rul. 9504041.

      8.    Rev. Rul. 69-141, 1969-1 CB 48.

  • 385. How are disability pension payments taxed to self-employed individuals when made from a qualified pension or profit-sharing plan?

    • Disability payments from a qualified plan receive different tax treatment, depending on whether the payments are made to common law employees (see Q 384) or to self-employed individuals.

      If a self-employed individual draws benefits from a plan because of permanent disability, the disability payments will be taxed under the same rules that apply to retirement benefits (Q 3969).

      If a self-employed individual receives disability payments through health insurance, the employee may exclude from gross income any amounts attributable to nondeductible contributions as a self-employed person.1

      Where contributions under a qualified plan are applied to provide incidental accident and health insurance for a self-employed individual, the insurance is treated as if the employee had purchased it directly from the insurance company.2


      1.    IRC §§ 105(g), 104(a)(3); Treas. Reg. §§ 1.105-1(a), 1.105-5(b).

      2.    See Treas. Reg. § 1.72-15(g).