Consider "Split-Dollar" Disability Insurance
This financial strategy can maximize the net benefit from your disability coverage.
BY MARK E. KROPIEWNICKI, J.D., LL.M.

Most ophthalmologists recognize that their chances of becoming disabled are greater than their chances of dying young. Consequently, many of you have obtained substantial disability insurance as a safety net to fall back on should you become disabled.

Over the years, physicians have handled the ownership and payment of disability insurance in a number of different ways. Some prefer to pay their the premiums individually from their personal, after-tax funds. These premium payments aren't tax deductible, but any benefits received upon disability are tax-free. Physicians who choose this option elect to forgo the tax deduction allowed for the premium because they believe they'll need the maximum amount of benefit, unreduced by taxes, should they become disabled.

Others have their professional corporation pay for the disability insurance. While the premium payments are tax deductible to the corporation, and not taxable to the doctor, when the physician receives any disability proceeds he must pay taxes on the money.

In this article, I'll explore a so-called "split-dollar" concept, which can help you to maximize your net benefits from disability insurance should you ever become disabled.

Making A Choice

When you apply for disability insurance, several factors determine the maximum monthly benefit the insurance company will issue. Among these are your income, other coverage you currently have in force, and whether you or your professional corporation/employer pays the premium.

Once the decision has been made to purchase disability insurance, the next question is: What's the most tax-efficient way to own this coverage? Both individual pay and corporate pay scenarios have tax and benefit consequences, which I'll discuss later. But first, I'd like to set up a typical scenario, which I'll use as the basis for my analysis. The conclusions that I draw would apply in most situations.

The scenario:

• the insured ophthalmologist is a male, age 45, with an annual income of $250,000
• the ophthalmologist is in a 35% marginal tax bracket
• disability occurs at age 45 and continues through age 65
• the disability policy contains a 6% Cost of Living Adjustment Rider
• the goal is for the ophthalmologist to receive the maximum benefit if disabled, with minimum tax consequences regardless of when, or whether, disability occurs.

(The split-dollar concept described here won't work for practices that are structured as "S" corporations, which can't deduct an owner's disability insurance premiums.)

The Individual Pay Option

Under the above fact pattern, an ophthalmologist paying for a policy with after-tax dollars would be eligible for a monthly disability benefit of $9,650, which would be received on a tax-free basis, for an annual premium of $7,660.

With this individual pay option, our goal of providing the maximum benefit if disabled is met because no taxes are due on the benefits paid to the ophthalmologist. However, if the ophthalmologist is never disabled, the tax consequences are considerable.

In a 35% tax bracket, the ophthalmologist must earn $11,785 in order to pay taxes of $4,124, leaving a net of $7,660 to pay the annual premium. Those taxes, which are paid to ensure that any benefit would be received income tax free, if invested at a 6% rate of return for 20 years, would grow to $160,835. To guarantee a tax-free benefit if disability were to occur, the ophthalmologist has lost more than $160,000 of wealth by age 65.

Assuming a 6% Cost of Living Adjustment, and a disability starting at age 45, a disabled ophthalmologist would receive a total net benefit of exactly $4,231,098.

The Corporate Pay Option

With the same fact pattern, when the ophthalmologist's professional corporation/employer pays the premium, he's eligible for a monthly benefit of $12,100 for an annual premium of $9,597. This higher benefit is available because any benefit the ophthalmologist receives if disabled will be received as taxable income.

What are the tax consequences of this arrangement? First, there are no negative tax consequences if disability doesn't occur, as the premiums were paid by the professional corporation and weren't included in the doctor's taxable income.

If disability does occur, the individual will receive a total benefit of $5,305,536. However, in a 35% bracket, he'll pay $1,856,937 in taxes, leaving a maximum total net benefit if disabled of $3,448,598. So, while there are no concerns about income taxes if disability doesn't occur, the ophthalmologist has lost more than $1.85 million to taxes if disability does strike.

How, then, can we structure disability coverage to maximize the total net benefits while minimizing the tax consequences under all scenarios? An understanding of the pricing and construction of disability policies will shed some light on a solution.

"Split-Dollaring" is the Answer

When analyzing disability policies, it becomes apparent that the premium is weighted towards a shorter-term disability. For example, the premium for our 45-year-old ophthalmologist on a monthly benefit of $9,650 payable to age 65 is $7,660. The premium for the same monthly benefit, payable for only 5 years, is $4,522. Stated another way, about 60% of the premium is allocated to the 5-year benefit, while 40% of the premium covers the remaining 15 years of benefits.

Remembering our goal of providing the maximum net benefit if disabled, while at the same time minimizing the tax consequences if disability doesn't occur, we would structure disability insurance coverage into two policies as follows:

• a policy with a monthly benefit of $9,650 payable to age 65, with a premium of $7660
• a policy with a monthly benefit of $2,450 payable for only 5 years, with a premium of $1,170.

The total premium of $8,830, would be split between the professional corporation and the ophthalmologist as follows:

• The professional corporation pays annual premiums of $4,522 toward the $9,650 per month benefit. This premium is the cost for the first 5 years of disability. It also pays annual premiums of $1,170 for the $2,450 per month benefit payable for 5 years.
• The balance of the premium, $3,138 on the $9,650 monthly benefit, would be "paid" by the ophthalmologist by treating it as W-2 compensation income to the ophthalmologist, which covers the benefit period from year 5 through age 65. In a 35% tax bracket, the ophthalmologist will pay taxes of $1,098 each year under this plan.

If he's disabled, the ophthalmologist will receive a taxable benefit of $12,100 per month for the first five years of disability, followed by a tax-free benefit of $9,650 per month for the balance of the disability, through age 65. This portion of the benefit is income tax free because the ophthalmologist paid for that portion of the benefit with after-tax dollars.

Comparing the Numbers

The chart below illustrates the differences between the three potential policy structures, in terms of premiums, maximum net benefits and tax consequences.

If disabled, the ophthalmologist will owe a maximum of $286,486 in taxes, resulting in a maximum net benefit of $4,110,034. The taxes due represent a reduction of $1,570,451 in taxes paid, as compared to the corporate pay scenario. If disability does not occur, the ophthalmologist's cost, in terms of taxes paid and the loss of the growth of those taxes at 6% over a 20-year period, is reduced to $42,828, a savings of $118,007 over the individual pay scenario.

It's Your Best Choice

In sum, structuring disability policies and premium payments under a split-dollar arrangement can provide you with essentially the same net benefit if you're disabled, and reduce your out-of-pocket tax costs associated with the ownership of disability insurance.

Mark E. Kropiewnicki, J.D., LL.M., is a principal consultant with The Health Care Group, Inc. and a principal attorney with and president of Health Care Law Associates, P.C., both based in Plymouth Meeting, Pa. He regularly advises physicians and practices on their practice management issues, financial matters and business law obligations. He can be reached at (610) 828-3888 or via e-mail at mkrop@healthcaregroup.com.