Many of my clients ask me the popular question: is disability insurance tax deductible? It may be a little complicated, but the real answer is maybe. It all depends on who provided the coverage and what type of business you own.
Even if they are tax-deductible, it may not be in your best interest to take that deduction. Why? Because if you did, the benefits would be taxable. If you pay with after-tax dollars (not deductible), the benefits would be received tax-free.
Unlike other health insurance (which disability insurance is technically classified as), you typically cannot deduct the premiums on your tax return. But because the premiums are paid with after-tax dollars, the benefits would be received tax-free during a claim.
Let's look at business owners to see if they can take a deduction for the premiums:
- Sole-Proprietor - A sole-proprietor is the sole owner of a business. Sole proprietors usually file a schedule C (which is where the tax deductions are taken). The issue is that sole-proprietors are not considered employees, but self-employed; thus, the premiums are not tax-deductible. The benefits would be received tax-free.
- Partnerships - The income from a partnership is not federally taxed and income (or loss) flows to the partners who are taxed based on their proportionate share of the profits of the partnership. Although the partnership can deduct the premiums paid to the partners as a guaranteed payment, the premiums are included in the partner's income. This means that although the partnership was able to make a deduction, the partner would be paying tax on the premiums. The benefits received would be tax-free.
- S-Corporation - Is taxed very similarly to a Partnership whereas the corporation does not pay federal tax and the income (or loss) is passed to the shareholders on a proportionate basis. The laws allow an S-Corporation to deduct the premiums, but if the owner owns more than 2% of the shares, the premiums are included in his/her income, making the benefits tax-free. In essence, with both a Partnership or an S-Corporation, the premiums are deducted by the business, but the premiums are included as income, so it is really a wash to the shareholder/partner and benefits are received tax-free.
- C-Corporation - C-Corporations are separate legal identities that file their own tax returns and pay their own tax. If you are a shareholder and also an employee, the corporation can deduct the premiums. If they do, the benefits received would be taxable. There can also be cost-sharing where the corporation pays the premiums and the employee/shareholder is taxed on part of the premiums. In that case, the percent of premiums that the shareholder pays taxes on would be received tax-free. For example, if the premiums for shareholder X are $3,000 annually and the shareholder elects to include $1,000 in his taxable income, then he would receive one-third of the benefits tax-free.