"Planning" for Disability

Having a qualified sick-pay plan in place can keep companies from falling into a tax trap. Ask any business owners if they would continue paying their own salary in the event they became sick or disabled and couldn't work, and the answer is likely to be a resounding "Yes." By doing so, however, a company could fall into a tax trap with serious consequences. Under IRC sections 105 and 162, a business cannot deduct wages paid to a disabled employee. The key word is wages. IRC section 106 requires that a company pay wages only to employees who render services. However, a company can pay wages to disabled employees under a section 105 qualified sick-pay plan (QSPP), described below. Businesses that have not yet adopted such a plan may wish to do so before disaster strikes and they must sacrifice valuable tax deductions to pay disabled employees. IT'S SIMPLE A QSPP is a simple arrangement that allows a business to continue paying some portion of an employee's wages during disability--and deduct the payments as usual. Any entity (corporation, partnership, professional corporation or sole proprietorship) can establish such a plan; but if you wait until the key employee becomes disabled to do so, it will be too late. For the benefits to be considered wages, the IRC says the company must establish the plan before an employee becomes disabled [see E. W. Chism Estate v. Commissioner, 322F. 2nd 956 (9th Cir. 1963)]. Under ERISA, the plan must be in writing, and each covered employee must be aware of its terms. Fortunately, the required documentation is not complicated, and many insurance companies have prototype documents available for a company's legal counsel to use in drafting the plan. If more than 100 employees are to be covered under the sick pay plan, then the plan documents must be filed with the Department of Labor. Otherwise, the documents are kept on file in the company's offices and included in the corporate minutes. LIFE WITHOUT A QSPP According to the IRS, the status of a disabled employee in a company without a QSPP is that of "ex-employee." The IRS does not consider any payments the company makes to an ex-employee wages; instead, they are "ad hoc" payments, which are not tax deductible. At age 40, the average duration of a long-term disability is approximately three years for men and almost four years for women. That can be a long time for someone to be out of work without pay. That threat alone should be an incentive for a company to put a plan in place to cover employees who become disabled. In assessing the need for a QSPP beyond securing a tax deduction, business owners--and the CPAs who work for or advise them--should ask themselves these questions: * What would happen to the business if a key employee was sick or hurt and unable to work? * Could the business sustain the potential loss of revenue, profit and productivity in the event a key employee was disabled? * Could the business afford to continue paying the disabled person's salary and pay a replacement--without the benefit of a tax deduction? Although no one can predict the future, an unexpected disability can create a serious dilemma for most small to medium-size companies. Fortunately, the solution is simple. Adopting a QSPP just formalizes what the business owner would do anyway--pay "wages" to the disabled employee. HOW IT WORKS The requirements for a QSPP include two documents: the plan resolution and a plan letter. Exhibit 1, page 62, shows a sample board of directors resolution. Exhibit 2, at left, is a sample of a plan letter. Exhibit 1: Sample Board of Directors Resolution(*) A special meeting of the board of directors of -- was held at -- on--,19--, at--o'clock. The following directors, constituting a quorum, were present: The president of the corporation acted as chairman of the meeting; the secretary of the corporation acted as secretary of the meeting. …