Disability Income • Critical Illness Insurance • Long Term Care • Life Insurance

IRC Section 105 Qualified Sick Pay Plans

Many firms do not realize that the IRS can disallow the deduction of wages (and the FICA contributions on them) to disabled employees, including payments to owner, family member and key-employees, because such wages are not considered a necessary business expense, unless they are paid pursuant to the terms of a Qualified Sick Pay Plan (pursuant to Section 105).¹ Importantly, the plan must be in place prior to the disability.²

A Section 105 Qualified Sick Pay Plan (QSPP) enables your firm to decide who will be paid, how much and for how long during the course of a disability. A QSPP can potentially save your firm and the disabled employee thousands of dollars in unnecessary taxes, penalties and lawsuits.

If you plan on paying wages to yourself or another employee during the course of a disability, do it legally, with a QSPP. You have nothing to lose and everything to gain by documenting and preparing in advance of a disability. A simple Plan Resolution and Plan Letter are all that is required. Remember, without a QSPP, the IRS says, "No Plan, No Deduction."

Adopting a QSPP does not require an insurance purchase. However, an insured QSPP contains three powerful tax shelters on covered employees:

An important side benefit of a QSPP is the simple Plan Resolution and the Plan Letters define who is a participant. This can be extremely useful should a disabled non-participant file for a claim.

I can provide your firm with sample documentation for use with your legal counsel.*

* A Section 105 Qualified Sick Pay Plan is not a policy, but rather an approach that enables a firm to make tax-deductible payments to disabled employees covered under the plan. A QSPP does not require filing with the IRS. Because each firm is unique in its business structure and employment circumstances, it is the responsibility of the firm to take the simple, yet necessary legal and accounting steps to properly implement a plan. In my capacity as an insurance advisor, I am not qualified to offer specific legal, technical and/or accounting advice. I recommend that you seek legal and accounting advice from your team of professionals on this matter. I will happily work with them in my capacity to provide documentation and arrange for the placement of insurance where required.

Establishing a QSPP solves the business tax problems, but a critical question remains. Should the QSPP be insured or self-insured?

Considerations in Funding a QSPP

As already stated, adopting a QSPP does not require the purchase of insurance. However, most firms choose to transfer some or all of the funding liability to an insurance company. Only through an insurance funding vehicle can the firm make small, deductible premium payments at the best possible time, when everyone is healthy and working. One alternative is to pay QSPP benefits out of reserves or current cash flow. However, the disability may come at the worst possible time, when a key-employee is no longer contributing to the bottom line.

Many times, a firm wishes to combine “self-insured” and “insured” components into its QSPP. Why? Because most insured plans typically have a 90 to 180-day waiting period before benefit eligibility. How does the disabled QSPP participant pay family bills while satisfying the waiting period? The firm can spell out in the plan document who, how much and for how long the benefits will be paid. With a QSPP, the firm is able to make its “self-insured” tax-deductible payments during the waiting period to plan participants. By limiting its exposure in this manner, the firm significantly reduces its current and future liabilities under FASB 112.

Insured QSPP’s typically pay participants between 60-80% of earned income. While a firm is also free to self-insure any difference above this amount, doing so substantially increases their current and future liabilities under FASB 112. This decision is different for each firm. In consultation with management, prudent advice should be sought from your team of professional advisors.

Certain design and administration issues must be addressed to develop an effective QSPP. Who will be covered, how much and for how long will the benefits be paid? Who will determine if a disability exists and who will decide when benefits payments will stop? Who will administer the plan and pay claims? How will the plan be funded?

It can be persuasively argued that disability income is the most effective way to install a QSPP. In addition to being well served by the tax laws, it provides documentation of the essential elements of the plan, i.e., monthly benefit amounts, benefit periods, definitions of disability, etc. It is the insurance company that provides policy administration, claims service and tax reporting. Importantly, the insurance company holds the financial liability for all future benefits, thus eliminating FASB 112 concerns (save any liabilities your firm assumes if it chooses to self-insure some portion of the risk).

Bottom line - few business owners are willing to risk their very future on an unknown liability. Even worse, there could arise the need for the firm to fund concurrent multiple disabilities.

Remember, on one hand, the IRS says “no plan, no deduction”. On the other hand, once a QSPP is adopted, it falls under ERISA and FASB 112 requirements. The following graph explains why most firms choose to insure some or all of their QSPP liabilities.

Consideration Self-Funded Plan Insured Plan
ERISA Requirements Plan document and description of employee benefits Insurance policy and plan document
Claims Determination You must decide if a covered employee is disabled Insurance company determines disability
Final Benefit Payment You must determine whether the employee has recovered Insurance company makes the determination
Cost/Timing You pay large benefit checks at the worst possible time — when a valuable employee is not working You make small premium payments when everyone is working
Liability You retain all of the liability for payments The insurance company assumes the liability

Clearly, after studying the facts, it's clear why self-insuring a long-term disability may be very costly to your firm.

Financial Accounting Standard Board (FASB) 112. This change in the generally accepted rules of accounting (effective for all fiscal years beginning after December 15, 1993) requires companies that self-insure their long-term disability claims must declare the net present value of all future payments as a balance sheet liability. The increase in liability must also be charged to earnings.

The financial implications of FASB 112 are particularly relevant to publicly traded companies.

The result is that the liability that companies must now post will be dramatically higher than the annual claims expense they reported in the past under the old pay-as-you-go, self-insured arrangement.

Under an insured Qualified Sick Pay Plan, the premiums are tax-deductible as a necessary business expense (IRC 162).

Premiums are not considered additional taxable compensation to the employee (IRC106).

Bottom line - few business owners are willing to risk their very future on an unknown liability. Even worse, there could arise the need for the firm to fund concurrent multiple disabilities.

¹ Estate of E. W. Chism and Chism Ice Cream Company, T. C. Memo 1962-b; Affirmed, 322F.2d (9th Cir.)(193)
² Robert L. Harris, 77-1 USTC Par. 9414 (E. D. Va 1977)

There is no fee for my services

Paul SuPrise, CLU, LTCP
770 Nuangola Road • Mountain Top, PA 18707-9507
570-868-6871 • Fax 570-868-6872
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