Podcast: Play in new window | Download (Duration: 1:08:20 — 156.4MB) | Embed

Subscribe Apple Podcasts | Spotify | RSS | More

An owner who runs a practice or a company as an S corporation pays themselves a modest base salary, takes the rest of the year’s profit as a K-1 distribution, then enrolls in the group long-term disability plan and treats the income question as settled. Most group disability plans never saw that distribution, because they define covered earnings as W-2 wages and stop there. Under that definition, the largest number on the owner’s tax return was never insured.

Grayson Owen has spent more than 12 years in the insurance business, and he now works in a corner of it most buyers never see. He is a disability income wholesaler at DI Broker East, which means advisors across the Mid-Atlantic, the Southeast and the rest of the country route their hardest income protection cases through him, the executives, partners and owners whose earnings a lot of other people depend on. He told me S corp owners make up most of the business owner files that reach his desk.

Covered Earnings Definition Inside S Corp Owner Disability Insurance

Covered earnings is the single line in a group long-term disability contract that sets the ceiling on any benefit it will ever pay. Most employer plans define it as W-2 wages, sometimes averaged across a stretch of months before the disability began. Profit distributed out of the S corporation sits outside that definition unless the plan was deliberately designed to reach it. The replacement percentage printed on the front of the plan document, usually 60 percent, gets applied to whichever number the definition allows.

That modest salary line has a reason behind it. The Internal Revenue Service requires an S corporation officer who performs services for the company to be paid reasonable compensation as wages before non-wage distributions are made, and owners and their accountants typically set that wage at a defensible floor and route the remaining profit through the K-1. That is ordinary tax planning. It is also the number a group carrier reads when it calculates a disability benefit.

Owen sees the result of that arithmetic in six and seven figures.

“A lot of the S corp owners might have very significant six figure, even seven figure K-1 distributions. That’s basically their business profit, how I understand it. I’m not a tax advisor, but K-1 is a type of income that the S corp owner distributes usually at year end, and those earnings may or may not be covered under the group plan depending on how they design it.”

Grayson Owen, a disability income wholesaler at DI Broker East who has spent more than 12 years in the insurance business reviewing owner-employee disability cases for advisors, speaking on the Income Protection Journal Podcast

“May or may not” is the operative phrase, and it is settled inside the plan document long before anyone gets sick. Almost no owner-employee has read that answer. The percentage is the number they remember, because the percentage is the number the enrollment material leads with.

If you own a dental practice, a law firm, a medical group or a construction company organized as an S corporation, this is your plan too. Most owners approve the group disability plan once, when it is first installed, often back when the company was smaller and the salary line was closer to the whole paycheck. Profit grows after that. The distribution grows with it. The covered earnings definition does not move.

Owners also miss it because the group plan reads like the more generous of the two products. Sixty percent replacement sounds close to whole. An owner drawing a $100,000 salary against a much larger K-1 hears 60 percent and pictures 60 percent of what the household actually lives on. The contract is measuring wages, and the household is spending income, and those two words point at very different numbers on the same tax return.

Here is the arithmetic I walk owners through. Say the owner pays themselves a $100,000 base salary and takes $900,000 in distributions, a common shape for a profitable single-owner professional company. Under the group policy, only that $100,000 counts as covered earnings, while the household is running on the full $1 million. An individual disability policy is what reaches the rest, because individual carriers underwrite total earned income and will issue a benefit that sits on top of whatever the group plan already pays. The group plan will not pay on the $900,000 no matter how the claim is filed.

Individual Disability Insurance for Business Owners Picks Up the K-1 Income

Individual policies reach the distribution because they measure income differently. Financial underwriting on an individual contract looks at total earned income, which for an S corporation owner-employee means the W-2 line and the K-1 line read together, usually across two years of returns. That is the number the benefit is built on. It is also why the application asks for tax returns rather than a pay stub.

There is a second route Owen spends much of his executive time on, and it changes who pays. A company can install a layer of individually owned coverage on top of the group plan for a defined class of people, issued with limited or no medical underwriting. Carriers will generally look at a class as small as five lives, and Owen said most of the private-company cases he manages run somewhere between five and 40 people, frequently family businesses with a core management team. Some designs true everyone up to the same replacement percentage. Others carve out a class by title, so anyone hired or promoted into it becomes eligible on arrival. Those policies are individually owned and portable, which matters more than most executives realize on the day they leave.

The reason so many owners never learn any of this, Owen argues, is that the conversation stops one question too early. An advisor asks whether the client has coverage at work, the client says yes, the box gets checked and the agenda moves on.

“We want them to say, ‘Hey, do you have coverage through work?’ The client’s going to probably say yes or no or I don’t know, and then after that, would you mind if we review that plan for you to make sure you’re okay?”

Grayson Owen, who spent nearly a decade as a consumer-facing insurance broker before moving to the wholesale side, where he now runs disability coverage reviews for advisors and their clients, speaking on the Income Protection Journal Podcast

That second question is where the review actually starts. Reading the plan document is what surfaces the covered earnings definition, and that definition is what decides whether an owner is insured on a salary or on a paycheck. Nobody finds it by asking whether coverage exists, because it does exist. It just does not reach as far as the owner believes.

So the practical move for an S corporation owner is narrow. Pull the certificate of coverage for your group long-term disability plan and find the covered earnings or covered monthly earnings definition. Read whether it says W-2 wages, base salary or total compensation, and whether the plan document mentions K-1 distributions anywhere. Then set that number next to what you actually reported as income. When I build income protection for small business owners, that comparison is the first page of the analysis, because everything downstream depends on which number the contract agreed to insure.

Timing decides the rest of it. Individual coverage is medically underwritten, and the owner who waits until the practice is at peak profit is also the owner who has accumulated the health history that shapes the offer. Owen made that point about himself on the record, naming his own diagnoses.

There is more in the recorded conversation than fits here, including the two medical policies another broker wrote without residual disability or true own-occupation language and what it took to rebuild them, what happens inside underwriting when a file was never pre-screened, and the one line Owen would put on a billboard for every owner who assumes the business will simply keep paying them. That conversation is on the Income Protection Journal Podcast. What stays with me is that the definition nobody reads is the one that sets the check.