What do you do when a key employee gets sick and exhausts paid time off? The logical thing is to hand him the statutory disability form and let the significant income be his problem. However, it doesn’t always happen that way. Often, a business wants to continue paying wages to a key employee, particularly a long-term leader. I have had personal experience with this twice in recent years, with the boards of 501(c)(3)s opting to pay a dying executive director and an ailing president, respectively.
A business owner would certainly not want to stop drawing salary because he was sick or disabled. However, did you know that by doing so, a company could face serious tax consequences? Pursuant to Internal Revenue Code sections 105 and 162, a business cannot deduct wages paid to a disabled employee. Section 106 requires that wages be paid only to employees who render services and under the code, a disabled employee is deemed to be a former employee. Hence, any payments are considered ad hoc.
The solution? A Section 105 qualified sick-pay plan (QSPP). Without such a plan, the wages paid are not tax deductible, creating phantom income to the employer. The documentation necessary to create a plan is simple (well, simple for me!): a plan resolution by the Board and a plan letter informing employees of the details. The resolution formally creates the QSPP and names the employees or holders of job titles who will be covered by the plan. One of the best features of IRC section 105 is that a business owner can elect to cover only certain employees as well as to vary benefits among them. He can pay only himself, including key employees, or pay some a greater percentage of their salaries while disabled. This offers the employer tremendous flexibility and the ability to offer a contingent benefit at the time of hire/contract negotiations. The provisions may vary as to percentage of salary to be paid, the duration of the payments (by age or number of years) and whether payments will supplement a long term disability program established by the employer. These can also be set based upon years of service or job classifications. An employer may self-fund the program or transfer the risk to another entity, an insurance company. The employer can offer a disability program in conjunction with the QSPP which is employee funded through payroll deductibles, creating exposure only for the percentage of salary stipulated in the plan resolution. If the employer is picking up the tab, the premiums are tax deductible. The plan can be amended at will-----provided that the employer does so prior to the disability of the covered worker.
As an employment lawyer representing management, the one theme I see repeatedly in the event of illness is the desire to continue paying the disabled employee’s salary at a time of tragedy conflicting with the inability to do this while paying a replacement. A QSPP provides a valuable option. The cost of setting up the plan documents is extremely low relative to the tax consequences of going without. And disability payments made to the employee under the auspices of this program are free from federal taxation.
A QSPP plan involves the participation of your benefits administrator, attorney and accountant. Because it needs the “triple play” approach, I find that many employers aren’t aware of the benefits and the downside risk of seemingly doing the right thing but violating the Internal Revenue Code in the process.
Judge Ruth Kraft chairs the Employment Law Group at Kirschenbaum & Kirschenbaum and works, in conjunction with tax professionals, to protect the interests of management stakeholders in all aspects of employment relationships. To discuss the establishment of a QSPP with Judge Kraft, contact (516) 747-6700 ext. 326 or RKraft@Kirschenbaumesq.com.