Salary Continuation Plans For Disabled Shareholders

Question: I own a 50% interest in a corporation and have concerns about what might happen if I become disabled.  Can I continue to receive a salary from my corporation if I become disabled?

Answer:  You raise an interesting and often overlooked concern. Many closely-held business owners automatically assume they will continue to receive salary from their companies after they become disabled. Various considerations arise with salary continuation upon disability.

The most obvious concern is securing a legal commitment from the corporation to continue paying your salary after you can no longer perform services for the company. Whatever shareholder agreement you have with your co-owner(s) should clearly document the intended arrangement.

While even the most trusting of co-owners may be comfortable with undocumented promises of salary continuation upon disability, securing the desired tax treatment requires some type of written salary continuation plan to be in effect.  The premise of salary payments for any business owner is that an employee is rendering services and being compensated accordingly.  Where a business owner continues to receive his or her salary after ceasing rendering services for the company, the IRS could take the position that the owner is receiving something other than salary since no current benefit is being provided to the company by the disabled shareholder.

In many cases, the IRS will seek to recharacterize payments to disabled owners as dividends.  If your corporation is a C corporation, this recharacterization could have a serious impact on the company as the corporation will be unable to deduct payments treated as dividends. C corporation owners often undergo extensive planning to avoid dividend treatment. The favorable tax rate on dividends received by shareholders will likely do little to mitigate the harshness of the corporation’s lost income tax deduction for salary payments recharacterized as dividends. Concerns may also arise with a S corporation which has accumulated earnings from prior years in which it operated as a C corporation.  Furthermore, any S corporation making salary continuation payments to a disabled shareholder which are recharacterized as dividends could be treated as having made disproportionate distributions to shareholders, thereby jeopardizing the entity’s S corporation status.

The IRS has for many years challenged arrangements where business owners continue to receive salary without a legal obligation of the company to make such payments. While challenges by the IRS have in some cases been defeated with minimal documentation such as corporate resolutions established prior to the onset of a disability, a more comprehensive plan should be adopted to support the intended tax treatment. Business owners should have their company establish a written salary continuation plan detailing the employees eligible for salary continuation benefits, the amount and length of benefits to be paid, how a participant’s disability will be determined and other relevant aspects of the arrangement.  By establishing a salary continuation plan prior to an owner’s disability, there is a much greater chance of defeating a government challenge to the desired tax treatment.   

Experiencing a disability can have a significant impact on the life of a business owner. Although many business owners enter into buyout arrangements for the purchase and sale of some portion or all of their equity interests, many fail to take the additional necessary step of documenting the intended salary continuation payments to disabled owners. You and your co-owner(s) should adopt an appropriate salary continuation plan to address your concerns.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.