Entrepreneurialism is alive and well, with thousands of upstarts becoming startups each year. The pattern is familiar: come up with a marketable idea, develop a business plan, attract funding, and then open shop. Just getting there is daunting, and soon other concerns loom, such as recruiting and retaining talent in a competitive marketplace. This particular challenge is a place where CPAs can play a key role.
Entrepreneurs with an eye on growth must recognize the need for a diligent and forward-thinking accountant, one who must in turn realize the exigency of a qualified sick pay plan (QSPP), a company’s formal plan for dealing with employee disability. Organized under section 105 of the Internal Revenue Code (IRC), a QSPP allows sponsors to deduct compensation paid to disabled stockholders rather than recognize it as a nondeductible dividend.
While operating without an ERISA-compliant plan seems innocuous, CPAs must realize that not having one is a lingering liability for all business owners, especially closely held businesses that want to keep key employees on limited payroll during times of inactivity. Done right, it’s a sound investment and an excellent way to build employee morale—done wrong, the lagging effects in mismanaging compliance with GAAP are dangerous to a company’s books.
The good news is that knowing how to treat disabled or sick employees without creating tax, accounting, and discrimination liabilities is surprisingly inexpensive, given the proper preventative advice. Many companies, however, do not learn about this critical need until it is too late.
Consider a simple case study (names have been changed): Universal Widgets, LLC, a small company where key employee Lauren Kim became an integral part of its growth. That ended five years into her career when she was diagnosed with bipolar disorder. Unable to be client facing, Lauren could no longer perform the material and substantial duties of her position. Grateful for her contributions to the company, Universal opted to give her a monthly salary of $6,000 while she recovered (40% of her previous salary). Eventually able to assume a back office support role at Universal, she returned and, paired with new hire Peter Matumbo, soon broke her previous sales records. Although not much of a salesman, Peter quickly saw his income skyrocket, largely thanks to Lauren.
All that ended with a biking accident so severe that Peter could not visit clients for the next six months. Given that impact on his commission-based earnings, Peter called Universal’s human resources (HR) department and told them he wanted to receive 45% of his weekly wages during his disability, just as Lauren had during her leave. Seeing him as expendable, Universal’s owners decided to give him monthly compensation of only $1,500, far less than Lauren had received. Subsequent to angry emails exchanged with the HR department, Peter filed a gender discrimination lawsuit against Universal Widgets for this disparate treatment.
This suit, still under investigation, was further complicated by problems that arose through an IRS audit; the agent told Universal that the monies Lauren received while disabled were not deductible without a QSPP agreement in place. Accordingly, Universal owed back taxes and was assessed a 20% underpayment penalty, had no legal standing to demand the money back from Lauren, and may not see see the 7.65% FICA tax it paid on the money returned. Equally distressing, nosy office neighbors saw the IRS agents and started spreading rumors Universal was being investigated, leading people to think the company was committing tax fraud. Coupled with Peter’s allegations of gender discrimination, this was a blow to Universal’s reputation. Since this digression is probable and the amount can be determined, it likely requires a contingent liability journal entry on the company’s ledgers.
A problem like this should not be blamed on any one of Universal’s accountant, legal team, or benefit advisor. It would have taken collaboration among all three experienced advisors to enact an effective strategy that is not strictly in any of their realms.
A Qualified Sick Pay Plan
Universal Widgets could have easily and affordably prevented this with proactive, rather than reactive, planning. Companies simply need a formal documented plan—a QSPP—to deal with employees’ disability, allowing the business owner to decide which employees will be covered and whether to transfer the risk to a commercial insurance carrier.
While a QSPP can be a self-insured legal agreement (i.e., an unfunded plan), most are funded contracts backed by individual disability income insurance policies offered to different employee tiers. The accounting guidance in SFAS 43, Accounting for Compensated Absences, which addresses the need to accrue a present liability for sick pay plans (qualified or not), is a significant factor in this trend. By funding the plan via a third-party insurer, SFAS 43’s QSPP requirements are muted. The two basic tailored approaches are as follows:
The unfunded QSPP.
This is an in-house solution that can be tailored by the company’s legal counsel and HR team either to target specifically qualified employees or have interpretable parameters. An unfunded QSPP is often perceived as the lowest-cost solution, but CPAs can reveal how looks can deceive. As determined by SFAS 112, Employer’s Accounting for Postretirement Benefits,companies must recognize the entire present value of projected liabilities under the QSPP as a current liability on their financial statements. This can affect credit lines, expansion plans, and owner’s compensation, making administration and claims management an added internal burden. Moreover, an in-house CPA may complain that administering employee disability claims under the QSPP has increased operating expenses (i.e., phone calls, paperwork, overtime) and the CPA may not favor leaving the liability for a disability claim up to the HR department.
The funded QSPP.
If an employer does not want to have the entire present value of its liability under the QSPP as a current liability on its financial statements, a QSPP funded with individual disability income insurance policies can be tailored to its specifications and have differing amounts, types, and durations of income (DI) policy benefits to different tiers of employees. Below are the two popular variations that businesses can use to structure their funded QSPPs:
Traditional QSPP (employee-owned DI policies).
The employer pays the premiums for the DI policies, deductible as a business expense, and employees are not taxed on premium payments. The employee is both policy owner and beneficiary. If the employee becomes disabled, any benefits received under the policy are taxable as income. The presence of the income from the DI policy is likely sufficient so that the business is completely relieved of making any additional payments to the disabled employee.
Contributory QSPP (employee-owned DI policies).
The DI premium cost is split between the employer and employee (the exact amount of the split varies). Employees pay their portion with an after-tax payroll reduction or by check directly to the insurance company. The employee is taxed on the monies contributed to pay the premium; the employer may deduct its portion. Any benefits from the policy are received tax free to the extent the employee contributes to the premium.
An Easy Solution
Because not having a QSPP in place creates accounting and legal liabilities, advice about its benefits from a CPA can lead to considerable savings and better company morale. To that end, CPAs should find a benefits consulting firm to add these simple documents—whether funded or unfunded—to the employer’s business records.