An unusual arrangement that provided disability benefits was at issue in the case of Estate of Barnhorst v. Commissioner, TC Memo 2016-177. The key issue was whether the benefit paid by the program in 2010 represented payments under an accident or health plan under IRC §105(a) and, if so, did the benefits received represent payments not related to the absence from work under IRC §105(c). The IRS claimed that, in reality, this was simply a deferred compensation plan and should be taxed as such.

The plan was a unique one set up by Mr. Barnhorst for his law firm. As the Court noted:

Early in his career, Howard met another attorney, Ernest Ryder. Ryder specializes in tax planning and retirement benefits and was United States counsel for American Specialty Insurance Group, Ltd. (American Specialty), a company organized under the laws of the Turks and Caicos Islands. BSG hired Ryder to write a policy to insure Howard. The policy was called Policy Number 1994-004. Ryder opened a Charles Schwab account under the name American Specialty Insurance Group, Ltd. Policy No. 1994-004 and had signature authority over it.

He also billed BSG for policy fees. It is this unusual feature—an insurance policy with its own brokerage account—that the reader should focus on, because neither the IRS nor the Court has ever seen the policy itself.

The program offered various benefits to Mr. Barnhorst, but the one in question in this case related to payment to him for “catastrophic disability.” The policy provided for payments of apparently varying based on different types of disability, though always capped at no more than 97% of the cash value of the policy.

However, the Court noted that this wasn’t exactly the case, as not only was 97% the maximum benefit, it also was the minimum:

These different categories of catastrophic injuries would seem to trigger different payouts (depending on the value of the policy and what he was making at BSG) -- except for one important clause. Provision 2.4(e) stated that "to the extent 97% of the cash value of the policy exceeds [Howard's] catastrophic disability benefit as based on a multiple of [Howard's] highest annual earnings * * * such excess shall be divided by the number of months in the maximum benefit period, and the resulting amount shall thereupon become the monthly disability income benefit." In other words, if Howard didn't get the full 97% cash value from a lump-sum payment from any type of catastrophic injury, he'd get the rest of it in monthly installments over the course of the benefit period, regardless of the type of "catastrophic disability" he suffered.

As well, if Howard was not disabled he ended up with the same 97% of cash value benefit, as the Court noted:

The policy had another important clause: It would terminate upon the earliest of: (1) Howard's turning 60; (2) his death; or (3) is no longer being an employee of BSG. If the policy terminated for either the first or third reason, Howard had the right to convert the coverage into a life-insurance policy with a cash surrender value equal to 97% of the cash value of the disability policy on the date of termination. Termination for the second reason would result in an immediate payout of 97% of the cash value to Howard's beneficiaries. Howard turned 60 in October 2008, thus presumably triggering a termination. But American Specialty continued to send renewal riders through a policy period ending February 1, 2010.

The opinion notes that the following standards are generally applied in case law for determining if a program is a health and benefit plan under IRC §105(a). These are:

A statement in a written plan that its purpose is to qualify as an accident or health plan within the meaning of the Code and that the benefits are eligible for income tax exclusion;
Specification in a plan that the benefits payable are those amounts incurred for medical care in the event of personal injury or sickness;
Terms in a plan that the benefits payable are limited to legitimate medical expenses; and
A provision allowing an employee to be compensated for specific injuries or illness, such as the loss of a limb.

There was no doubt the plan stated it intended to qualify as a plan under IRC §105, but the Court was more skeptical about the plan’s qualification under the second two provisions, noting:

The second and third factors—which are so similar that we'll treat them together—are a bit more complicated. Assuming the policy didn't terminate, Marnie is right that the only way Howard could get money out of the policy was if he sustained some kind of injury or illness. This is in stark contrast to a typical deferred-compensation plan that might involve some vesting and that could be paid out for non-health-related reasons. But payouts under this policy had no correlation with Howard's actual medical expenses—under its terms he would receive either a lump sum or a fixed monthly benefit. The amount of this payment had nothing to do with his actual expenses. He would, for example, be entitled to the same amount if he lost hearing in one ear or the use of both his kidneys. Medical expenses for these two conditions would quite likely be different, but payout under the policy would be the same.

That’s a crucial distinction. The cases tell us to ask whether a plan pays for actual medical expenses, not whether its payee suffers from some triggering condition. In Berman, the court said we look to see if the plan covers expenses "incurred for medical care."4 925 F.2d at 939 (emphasis added). Berman itself dealt with a plan that had a "triggering event" and found it to be only a deferred-compensation plan. Id. at 940. In Estate of Hall, we similarly concluded "that the disability provision in the * * * plan was merely one of several events that could trigger a participant's claim to accrued retirement benefits." 1996 WL 89625, at *5. In discussing these same factors, the Second Circuit in Caplin v. United States, 718 F.2d 544, 549 (2d Cir. 1983), stated the plan "could also specify that the benefits payable be limited to those amounts incurred for medical care in the event of personal injury or sickness, and provide for the specific reimbursement of such expenses." (Emphasis added.) The disability policy here distinguished between partial and total disability in its definitions, but once Howard suffered either condition, the payout to his family would be the same. Therefore, we find this factor to favor the Commissioner.

As well, the court notes both that, under the terms of the plan, the policy should have terminated at age 60 but was extended without an additional premium for additional years of coverage and that he no longer practiced law in the firm that sponsored the plan, and that entity no longer conducted any significant business. While the Court stated it did not use these considerations specifically to find that this was not a §105(a) plan, it did “sway” the Court in the IRS’s direction.

The Court went on to note that, as well, the payment did not meet the requirement of an excludable benefit under IRC §105(c)(2). Such a benefit must be one computed with regard to the type of injury—but in this case, while the type of disability might affect the timing of payments, it ultimately had no effect on the total amount of benefit, as it would always end up at 97% of the cash value.

As the Court notes:

We do not doubt that Howard's cancer and surgery might have qualified him for income exclusion under an accident or health plan that met all of the requirements of section 105(c). But that is irrelevant—we have to see if the policy by its terms qualifies. See Rosen v. United States, 829 F.2d 506, 509 (4th Cir. 1987) ("[F]or payments to be excludible from income under section 105(c), the instrument or agreement under which the amounts are paid must itself provide specificity as to the permanent loss or injury suffered and the corresponding amount of payments to be provided. * * * The actual permanency of injury is not alone determinative of whether the amounts paid qualify for exclusion"); Estate of Hall v. Commissioner, T.C. Memo. 1996-93 (citing Rosen and holding the same).