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What is Disability Buy-Out Insurance?
Disability buy-out insurance is designed to provide the
funds needed to purchase a disabled owner or partner’s
interest in the business if they become disabled. Disability
buy-out insurance should be made part of any business
continuation plan or business succession plan as it will assure that the
disabled business owner receives a fair market value for
his or her interest in the business. At the same time, it
will protect all business owners from the threat that a disability
may impose on the company by allowing them to buy-out the
disabled owner’s interest at an agreed upon price set
forth in a buy-sell agreement
How does disability buy-out insurance work?
Before a disability buy-out policy can be purchased, the
business must be properly valued and a buy-sell agreement
must be executed. Once a fair market value for the business
has been determined, a sales price can be agreed upon and
a disability buy-out policy can be purchased on the life
of each business owner or partner to provide the needed funds
in the event he or she becomes disabled.
In the event of a disability, there is a “waiting
period” called the elimination period that must be
satisfied before benefits are paid. The elimination period,
selected at the time of application, begins at the date of
initial disability and can extend out 12, 18 or 24 months
depending on the terms of the buy-sell agreement and the
needs of the business. The longer the elimination period,
the lower the cost of the coverage will be.
With a disability buy-out, once the elimination period is
met, benefits begin and there is no need to confirm continual
disability. Once a claim starts, the terms of the buy-sell
agreement will be fulfilled and the policy will pay benefits
accordingly. There are several benefit payment options including
a lump-sum payment or scheduled payments over the course
of two, three or five years. A buy-out policy can be custom
designed to meet the specific needs of each company.
Why buy disability buy-out insurance?
The statistical probability of an individual disability
is greater at any age than the likelihood of death in that
same year. The disability of an owner who is active in the
day to day operations of the business can present huge financial
problems. To understand more about the potential threat a
disability may be to your organization, ask yourself the
following questions:
1.
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What impact would the disability of a partner
who is a key contributor have on the company’s
income? |
2.
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Where will the money come from to pay an income to
the disabled owner? |
| 3. |
Does the business have adequate funds to buy out the
disabled partner’s share? |
4.
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Will the firm have to borrow money to buy out the disabled
partner? |
Important considerations of disability
buy-sell planning
1.
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What defines a disability from the business’ perspective?
This must be established in the buy-sell agreement prior
to executing a disability buy-out policy. |
2.
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How long does a partner have to be disabled before
the buy-out is executed and the disabled partner’s
interest is sold to the remaining partners? As mentioned
above, the elimination period is generally set for 12
to 24 months depending on the terms of the agreement. |
| 3. |
What are the terms of the buy-out? Will benefits be
paid in one lump-sum or over time? |
4.
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What if the disabled individual recovers after the
buy-out is triggered and the disability policy ceases
to pay benefits? |
Taxation of
Disability Buy-Sell Plans
The premium payments for disability buy-sell policies are
not tax deductible. Therefore, the benefits received are
income tax free. Depending on the type of entity, corporation
or partnership, the recipient of the benefits may be subject
to capital gains taxes, gift taxes or if the company receives
the proceeds to disburse, be subject to the Alternative Minimum
Tax.*
For additional information on business planning
see:
* Neither MEG Financial nor any of its
licensed agents are providing specific tax advice. All tax
related questions
should be directed to your company’s CPA or tax advisor.
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What
is Disability Buy-Out Insurance?
