Exclusion of disability benefits from tax

By Eric T. Weiss, Esq.

Many physicians have disability policies where the premiums are paid by their employer, whether it be their medical practice or other employer. In the event of disability, benefits are taxable unless the disability and the plan itself satisfy a two-part exclusion test contained in Section 105(c) of the Internal Revenue Code.

The purpose of excluding benefits from tax was aimed at providing relief to persons who suffer serious, permanent and physical injury and receive compensation because of it. Despite this intent, the two-part exclusion test had been uniformly interpreted against the taxpayer since inception.

A recent victory by a taxpayer/physician in the case of Stolte v. Commissioner will likely have a profound effect on this law, making it possible for taxpayers to exclude disability benefits obtained from policies paid by their employer.

Section 105(c) allows the exclusion from tax where the benefit: (1) constitutes payment for the permanent loss or use of a member or function of the body, or the permanent disfigurement of the taxpayer, and (2) is computed with reference to the nature of the injury without regard to the period the employee is absent from work. Both of these requirements must be satisfied in order to exclude the benefits from tax.

Permanent Loss of Member or Function

In order to satisfy the first element of Section 105(c), the courts have focused on the severity of the disability. Prior case law has held that loss of sight constitutes loss of bodily function and loss of virtually all respiratory function constitutes loss of bodily function. A brain aneurysm that prevented a physician from practicing medicine and prevented him from performing the duties of any occupation in a meaningful and productive manner also constituted loss of bodily function.

Conversely, the courts have held that the following ailments do not constitute a loss of bodily function:

• Loss of heart tissue which does not cause the heart to function abnormally.

• Hypertension which caused the taxpayer to discontinue a high stress position.

• A compression fracture of a thoracic spine which did not prevent a taxpayer from working a less physically strenuous job.

Stolte v. Commissioner: Victory for Taxpayer

In this case, the Tax Court held that a surgeon who suffered an impairment to his hands, legs and feet due to polyneuropathy caused by chemotherapy satisfied the loss of bodily function requirement. Based on Dr. Stolte’s testimony and other evidence presented at trial, the Tax Court concluded that his condition is severe and permanent and has left him without functional use of his hands, legs and feet. His condition “…robbed him not only of his ability to function as a general surgeon, but also his ability to lead the life he enjoyed before his condition.” The government unsuccessfully argued that there must be a complete and total loss of ability to perform any job to satisfy the first test of Section 105(c).

Disability Benefits Computed with Reference to Nature of Injury

The second part of the exclusion test is more difficult to satisfy since the courts’ focus has been on the language of the disability policy and not on the condition of the disabled person. The courts had consistently decided Section 105(c)(2) against the taxpayer prior to the Stolte decision. Courts looked at several factors in analyzing whether the benefits were computed with reference to the nature of the injury including (1) whether benefits vary under the policy based on the nature and severity of the injury; (2) whether payment is based on compensation or years of service and (3) whether payment is based on the amount of funds held in a disability plan.

Very few policies provide benefits based on the nature of the disability. Most policies merely provide that a person receives a set monthly benefit if the injury or illness satisfies the policy’s definition of a disability. It is up to the taxpayer to find the variances that exist in their policies and present these variances in a manner to satisfy the second element. In the Stolte case, the policy provided five different payment categories even though four of the five paid a $2,500/month benefit but for different durations. The court found that the policy satisfied the second element.

Most disability policy benefits are computed on the basis of the salary or income history of the disabled person. As a result, the courts have consistently ruled that the benefits are subject to tax as substitute wages. In Stolte, the $2,500/month benefit was based on 30 percent of his wages at the time the policy was purchased, plus $800, with a maximum benefit of $2,500. The court found that this arrangement was not computed on the basis of Dr. Stolte’s salary.

Compensation based on years of service was not an issue in Stolte as the disability benefits were clearly not computed based on the number of years of service. If a taxpayer receives the same benefits as anyone else with the same number of years of service regardless of the type and severity of the injury, this will likely fail to satisfy the second element.

If a policy paid an insured his actual compensation based on the period he is absent from work, the policy would appear to be a substitute for the taxpayer’s salary and would be includible in income. The only cases which held that payments are based on absence from work involve policies which provide that payments are expressly contingent on not being able to work. Regarding the policy in Stolte, the Tax Court observed: It is not related to the period of time petitioner is absent from work as the policy contemplates that petitioner may engage in any employment or occupation while disabled as a surgeon.

The Tax Court distinguished prior case law which made it virtually impossible to satisfy the second element of Section 105(c). The Stolte court more reasonably interpreted the “based on compensation” requirement by finding that the policy satisfied the second element even though it was predicated on a formula which took into account Dr. Stolte’s income at the time his employer purchased the policy. Furthermore, its finding that the policy varied even though four of the five payment categories provided for a $2,500/month benefit regardless of the type of injury or illness shows that the policy need not provide differing benefits to specifically named disabilities or illnesses in order to satisfy the “benefits must vary” requirement. It was sufficient that the benefits varied as to the duration of payment based on when the injury or illness occurred.

The holding in Stolte makes it possible for a taxpayer to obtain the intended benefits of the law with its more realistic interpretation of the first element of Section 105(c) which requires a severe and permanent loss of bodily function but not a total loss of function. It also makes it possible to satisfy the second element of Section 105(c) even if the policy benefits do not significantly vary and are based somewhat on the prior compensation of the insured.

Eric T. Weiss, Esq. is a shareholder at the law offices of Bassey and Selesko P.C., located in Southfield, Michigan, and is Chairperson of the State Bar of Michigan Taxation Section.