377 / What are the tax consequences when a corporation buys disability insurance on a key person under which benefits are paid to the corporation?

A corporation cannot deduct premiums it pays but can exclude insurance benefits from its gross income.¹ Disability income, regardless of amount, is wholly tax-exempt to the corporation under IRC Section 104(a)(3).² Because the disability income is tax-exempt, a deduction for premiums is disallowable under IRC Section 265(a)(1) on the ground that the premiums are expenses paid to acquire tax-exempt income.³ An accidental death benefit may be tax-exempt to a corporation under IRC Section 101(a) as death proceeds of life insurance ( Q 63). Premiums paid for tax-exempt accidental death coverage are nondeductible under IRC Section 264(a)(1) ( Q 262).

On January 16, 2009, the Office of Associate Chief Counsel (Income Tax & Accounting) issued Chief Counsel Advice⁴ concluding that a taxpayer may not take a deduction under Section 162 for compensation paid to an employee pursuant to an employment contract, because the taxpayer was receiving disability insurance payments on account of the employee’s injury and Section 162 disallows a deduction for an expense for which there is a right or expectation of reimbursement.

However, upon further consideration, the Office of Associate Chief Counsel (Income Tax & Accounting) concluded, based upon the facts in the prior CCA, that a taxpayer is not precluded from taking a Section 162 deduction for compensation paid to an employee pursuant to the employment contract merely because the taxpayer received insurance payments on account of an employee’s disability. Nor does Section 265(a)(1) disallow such a deduction.⁵

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1.     Rev. Rul. 66-262, 1966-2 CB 105.

2.     Castner Garage, Ltd. v. Commissioner, 43 BTA 1 (1940).