What Is an IRS Insurance Disallowance?

An insurance disallowance is a formal action by the Internal Revenue Service (IRS) to deny a business’s tax deduction for an insurance premium. When a business pays for insurance, it records this cost as a business expense to lower its taxable income. A disallowance means the IRS has determined a premium does not qualify as a legitimate business deduction.

This is a tax issue, not an insurance one, and does not invalidate the policy or its coverage. The IRS is simply stating the cost of the coverage cannot be used to reduce the business’s tax obligation. This determination increases the business’s taxable income, resulting in a higher tax liability, and potentially penalties and interest.

The “Ordinary and Necessary” Test for Insurance Premiums

The foundation for deducting insurance premiums rests on the “ordinary and necessary” test. This two-pronged test is the primary filter the IRS uses to determine if an insurance cost is a legitimate write-off, and both conditions must be met. An expense is “ordinary” if it is common and accepted within your specific trade or industry.

The second part of the test is whether the expense is “necessary,” meaning it is helpful and appropriate for the business. It does not have to be indispensable for the business to operate. The IRS looks for a clear connection between the insurance coverage and the business’s operations. For example, a bakery purchasing fire insurance for its building would pass this test, as fire insurance is common for property owners (ordinary) and appropriate for protecting a business asset (necessary).

Commonly Disallowed Insurance Expenses

Life Insurance Where the Business is a Beneficiary

When a business pays premiums on a life insurance policy for an officer, employee, or any person with a financial interest in the business, those premiums are not deductible if the business is a direct or indirect beneficiary. This rule applies to key-person insurance, where the business insures an employee and receives the death benefit. Since the death benefit is received tax-free, the premiums paid to secure that benefit cannot be used to lower taxable income.

Coverage for Lost Earnings

Premiums for policies designed to replace a business owner’s personal income due to disability or sickness are not deductible. The IRS considers this a personal expense because the policy benefits the owner directly. However, a distinction applies to “business overhead expense” (BOE) insurance. Premiums for BOE policies are deductible because the policy is designed to cover fixed business expenses—such as rent and employee wages—if the owner becomes disabled, keeping the business operational.

Self-Insurance Reserve Funds

Some businesses self-insure by setting aside funds to cover potential future losses instead of paying a third-party insurer. The amounts allocated to a self-insurance reserve fund are not deductible. The IRS does not consider these contributions to be true insurance premiums because no risk has been transferred to an independent entity. A deduction is only permitted when an actual loss is incurred and paid from the reserve.

Certain Captive Insurance Arrangements

A captive insurance company is a subsidiary owned by the business it insures. The IRS scrutinizes them to ensure they operate as legitimate insurance companies. Premiums paid to a captive may be disallowed if the arrangement lacks adequate risk-shifting and risk-distribution. The IRS may view the premiums as a non-deductible deposit to cover the parent’s own losses rather than a true transfer of risk.

The IRS Disallowance and Response Process

The disallowance process begins when a taxpayer receives a formal notice from the IRS, such as a CP2000 notice or a formal audit report. A CP2000 is generated when information on a tax return does not match data the IRS received from third parties, while an audit report follows an examination of the business’s records.

Upon receiving a notice, the business owner has two primary paths. The first is to agree with the IRS findings, sign the response form, and pay the additional tax, interest, and penalties owed.

The alternative is to disagree. If you believe the insurance premium was a legitimate expense, you must formally respond to the IRS in writing by the deadline specified in the notice, which is usually 30 or 60 days. This response should state the disagreement and provide a detailed explanation of why the deduction was proper.

This written response must be supported by documentation, such as a copy of the insurance policy, proof of premium payments, and a statement explaining the business purpose. After the IRS reviews the response, it may accept the explanation, request more information, or forward the case to the IRS Independent Office of Appeals.