NOW BACK TO TUKA AND DISABILITY INCOME RULES.

FACTS:

Peter piloted planes for U.S. Airways.

Under collective bargaining, his company provided him and other pilots with a disability income plan.

Peter could no longer fly because of carpal tunnel syndrome.

As a result, Peter was eligible for disability benefits and in 1999 was paid $83,046.54 under the plan based on his age, years of service, and salary. (The amount he was paid was not based on his medical condition).

The insurer reported the disability benefits as taxable income (" Wages, tips, other compensation ").

But Peter didn’t report the disability benefits as income on his IRS Form 1040.

He argued that because of the wage concessions made by U.S. air pilots, the benefits should be income tax excludable.

Both the IRS and the Court disagreed.

COMMENT:

Although the general rule is that “Gross income includes income from whatever source derived”, there is a specific exclusion for amounts received through accident and health insurance for personal injuries or sickness.

This income tax exclusion, however, does NOT include - amounts received by an employee to the extent such amounts:

(1) Are attributable to contributions by the employer which were not includable in the gross income of the employee or

(2) Are paid by the employer.

In other words, if your employer pays for your disability income coverage and you pay no tax on those premiums, the benefits you get are taxable.

Here, the amounts Peter received under the disability plan of accident and health insurance were for personal injuries or sickness. He could have excluded the benefits he received – if he had paid after-tax premiums for the disability plan or if his employer paid premiums and the premiums were includable and reported in his gross income.

Peter argued that in reality, as an employee of U.S. Airways, he did pay – at least his share – of the contributions that were made to the pilot disability plan through wage concessions in exchange for the disability benefits package.

But the point is that benefits received under a disability plan are includable in income unless the contributions to fund that plan were previously includable in gross income.

The court here refused to accept that “in reality, the contributions were made by U.S. Airways employees, including petitioner, via the wage concessions” because, “ to accept petitioner's position would essentially qualify any negotiated disability package for exclusion under section 104(a)(3) since any such package could be construed as a substitute for wages that employees might otherwise receive. We cannot agree that Congress intended section 104(a)(3) to be read so broadly as to exclude accident or health insurance benefits attributable to wage concessions made in a negotiated bargaining process.”

IT’S AFTER-TAX DOLLARS THAT COUNT!

Code Section 104(a)(3)’s exclusion from income of disability income benefits contemplates that its exemption is predicated on after-tax contributions. In other words, “if an employee is to exclude disability benefits attributable to employer contributions, those contributions must have been includable in the employee's gross income.” Since contributions made on Peter’s behalf were never subject to income tax, they cannot qualify under this test.

Could it be argued that any contributions made by his employer to the plan "would be constructive income to him and so they were includible in his gross income for each year the contributions were made? Sure, it could be argued. But the argument would fail. Generally, under Code Section 106, an employee’s gross income does not include employer- provided coverage under an accident or health plan.

Code Section 105(a) specifically includes in gross income amounts received by an employee through accident or health insurance for personal injuries or sickness - to the extent such amounts:

(1) Are attributable to contributions by the employer which were not includable in the gross income of the employee, or

(2) Are paid by the employer.

GROSS INCOME DOES NOT INCLUDE:

Code Section 105(b) limits the application of Code Sec. 105(a) for certain amounts which are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care of the taxpayer, his spouse, and his dependents. (e.g. MERP : Medical Expense Reimbursement Plans). These are really one of the most incredible – and least utilized – techniques in the tax law.)

Further, gross income does not include disability benefits to the extent that they constitute payment for the permanent loss or loss of use of a member or function of the body, or the permanent disfigurement, of the taxpayer, his spouse, or a dependent, and which are computed with reference to the nature of the injury without regard to the period the taxpayer is absent from work. Sec. 105(c).

The exclusions under sec. 105(b) and (c) do not apply to the facts in the instant case and Tuka made no argument that they do.

As a last resort, Tuka argued that the "US Air, Inc. Pilot's Working Agreement" must be construed in conformance with the laws of the Commonwealth of Pennsylvania, which prohibit taxation on disability payments because they are not considered to be the property of the beneficiary.

The court made short shrift of that argument with this bah humbug statement:

“This case raises a question regarding the application of sec. 104(a)(3) of the Internal Revenue Code. Whether the Commonwealth of Pennsylvania expressly prohibits taxation of disability payments has no relevance in deciding the issue before us.”

WHAT DID WE LEARN FROM THIS CASE?

Tuka shows the tax leverage from buying and paying for your own disability income coverage. If your employer pays for your disability coverage, when the benefits come in (when times are really tough and you need every dollar), they’ll be taxable (and ironically make it more difficult to deduct your personal medical expenses – so you’ll owe more taxes and have even less income).

If you pay for your own disability coverage, benefits will be tax free.

Tuka also shows the importance of having an adequate amount of disability income coverage.

Don’t count on Social Security for any meaningful disability coverage. You practically have to be a – well – unable to perform ANY job – and your disability payments will not even kick in – until you’ve been totally incapacitated for a year!

All the estate planning we do may be of little help if a client is not adequately prepared for disability. And few corporate employers provide sufficient coverage. Fewer law and accounting firms provide sufficient coverage.

Think about suggesting to your clients that they review their coverage. Think about checking out your own.

And remember that all the coverage you have with your employer may be lost – if you – for any reason – are no longer working for that employer!

WHAT TO GET WHILE THE GETTINGS GOOD:

If you can afford it and can qualify for it, get a disability policy that:

  • Is Noncancellable
  • Has a “Your own occupation” definition of disability (It pays if you can’t perform the duties of your own job)
  • Has a rider that provides for inflation increases
  • Gives you the right to buy more coverage as your income grows
  • Provides benefits to age 65 (or the longest benefit period you can afford)
  • Provides partial benefits for partial disability
  • Provides the longest waiting period you can feel comfortable with (the longer you have to wait for benefits, the lower your premiums)

HOPE THIS HELPS YOU HELP OTHERS!

Steve Leimberg

CITE AS: Steve Leimberg’s Estate Planning Newsletter – 507 Copyright LISI 2003 To access LISI’s database or join LISI , go to http://www.leimbergservices.com

CITES:

Thomas D. Tuka v. Commissioner; 120 T.C. No. 1; No. 12224-01 January 6, 2003; IRC Secs. 104 , 105 , and 106 ; See Trappey v. Commissioner, 34 T.C. 407 (1960); Andrews v. Commissioner, T.C. Memo. 1992-668. Miley v. Commissioner, T.C. Memo. 2002- 236.

Medical Reimbursement Plans (MERPs) are covered in detail in Tools and Techniques of Estate Planning and in Tools and Techniques of Employee Benefit and Retirement Planning (800 543 0874). See J. Kim, “Ruling Shows Benefits of Paying for Your Own Disability Products”, WSJ Feb 5, 2003, B7A.