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A Sick-Pay Plan Can Help You Build a Healthy Business
 Consider this situation: A key employee or even your business partner (and co-owner of your company) has a mild heart attack. His physician says he can return to work in six months. But in the meantime, his family counts on his salary.
The company is doing well and you want to do the right thing. Do you continue to pay him? If so, what are the effects?
For the answer, we need to look at a landmark case that was decided in the federal courts back in 1963 {E.W. Chism Estate v. Comm’r, 322 F. 2d 956 (9th Cir. 1963)}.
The court found that the Chism Ice Cream Company did not have a sick-pay plan in effect before Chism was disabled and had not provided any formal, written communication to employees. Therefore, “sick-pay” payments made to Chism were not a tax-deductible business expense, but rather dividends.
A key employee’s disability is a serious problem for a small business and a lot more probable than most small-business owners realize.
Statistics show the staggering chances of a disability of 90 days or more occurring before age 65. For example, in the case of two 30-year olds, there’s a 55.2% chance; a 64.3% chance in a group of three 40-year olds; and in a group of four 50-year olds, there’s a 64.2% chance that one of them will become disabled. The odds are even higher for women. (Source 1985 CIDA and 1980 CSO).
The IRS Says: No Plan — No Deduction!
As far as the IRS is concerned, all monies paid as well as FICA contributions made on behalf of disabled employees are not considered wages unless the business has established a qualified sick-pay plan.
Although one would think all wages would be tax-deductible as business expenses, IRS rulings and regulations clearly indicate that “wages” can be paid only to an employee. According to the IRS, an employee is someone who
- Currently is performing services, or
- Is receiving benefits under the terms of an IRS Section 105 qualified sick-pay plan — or QSPP
Pay to disabled employees not covered by a plan is considered ad hoc payment and not deductible as a business expense. What’s more, payments made to owner-employees may be considered dividends as well. The result of all this is quite clear: No plan — No deduction.
Employers who think they’ll simply establish a plan if and when a disability occurs face the same consequences. The plan, according to the IRS, must have been in place prior to the disability and it must have been communicated to the employees.
What Is a Qualified Sick-Pay Plan?
A QSPP is simply a formal agreement that provides for a firm to continue some or all the wages of employees, including stockholder employees, during a disability.
Just about every kind of business entity can and should establish a QSPP — corporations, partnerships and sole proprietorships.
Plans must be in writing, and each covered employee must be aware of the plan’s terms. And as previously stated, the plan must be in place before a disability occurs.
While most larger, more established businesses have a formal sick-pay plan, the vast majority of small businesses have no plan in place.
Under Section 162 of the Internal Revenue Code, payments made to an employee under an accident and health plan are deductible to the employer. This is true whether the plan is insured or self-insured by the employer.
A sick-pay plan must be deemed to be for the employees’ benefit.
Unlike Employee Retirement Income Securities Act of 1974 (ERICA)-governed pension and retirement plans that carry rigid limitations and restrictions, however, a QSPP can cover one or more employees. And the employer may establish different plans for different classes of employees.
Although certain ground rules should be followed, the opportunity for creative plan design appears to be limited only by the imagination and ingenuity of the employer and the employer’s advisers.
No IRS Approval Required
What does it take to establish a QSPP? First, it’s necessary to have a formal plan document that sets out:
- Who to pay
- How much to pay
- When payments begin
- How long payment will continue
Sample prototype documents are available that companies easily can use, along with sample resolutions and suggested letters that need to be provided to covered employees. While plans are referred to as “qualified,” it is important to note that no IRS approval is required.
Establishing a formal sick-pay plan solves the business’s tax problem, but a critical question still remains. Should the plan be insured or uninsured?
Although a plan need not be insured to satisfy the tax law, an insured plan offers business owners significant advantages.
- First, the business pays the premium on individual disability income polices for each covered employee.
Premiums are tax-deductible to the business and are not considered taxable income to the employee. An insurance policy will clearly define the benefits; including when and for how long payments will be received — sparing the business owner the difficult problem of deciding the validity of a claim and when the person is able to return to work.
- Equally important to many owners of small businesses, the cost of premiums to fund the plan is fixed. Small, budget-able premiums are established at the best possible time — when everyone is well and working.
If self-funded, the business could face a potentially enormous, unplanned cost at the worst possible time — when a key employee is disabled and not contributing to company profits. Consider that for a male age 40, the average duration of a disability before age 65 that lasts 90 days or more is 3.5 years. This is the average, which means some may be much shorter — while others may be far longer.
- Finally, there is the question of financial liability. Under an uninsured (self-funded) QSPP, the business is liable for all agreed-upon benefits.
Under Financial Accounting Standards Board Rule #112, any firm using Generally Accepted Accounting Principles (GAAP) must admit the net present value of all existing claims along with the net present value of all future payments for them on its financial statement.
Thus a plan covering several disabled key employees would need to project the potential full cost of the possible liability. With an insured plan, the insurance company assumes full liability for all insured benefit payments (the insurance company admits the liability on its annual statement).
Louis F. Rendemonti, CLU ChFC, is the president of Suncoast Wealth Management, a Sarasota, Fla.-based financial services firm dedicated to helping owners and employees of companies involved in home building Industry. For more information, e-mail Rendemonti, or call him at 941-378-7883.
Republished with permission from Louis Rendemonti and the Florida Association of Home Builders — www.fhba.com.
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