Disability buy-out insurance: funding a buy-sell when an owner is disabled

A disability buy-out policy pays a lump sum or a series of payments when a business owner is disabled for long enough that the buy-sell agreement lets the other owners purchase the disabled owner's interest. It exists because a buy-sell agreement funded only with life insurance does nothing when an owner is alive but unable to work. Without a funded plan, the healthy owners often carry a non-working partner on the books while income drops and a purchase price has to come from somewhere.

The gap that life insurance leaves

Most closely held businesses insure the death of an owner and stop there. Death is certain to happen eventually, but a long-term disability during the working years is a real possibility, and it is a harder event for the business to absorb. The disabled owner still owns a share of the company, may still have a personal guarantee on a loan, and needs cash for living expenses and medical costs. The working owners are doing two jobs.

A buy-sell agreement can treat disability as a triggering event, alongside death, retirement and divorce. The agreement says when the disabled owner can be bought out, at what price and on what terms. A disability buy-out policy supplies the money. Without it, the agreement may promise a purchase the company cannot finance, and the price may be paid over many years out of the remaining owners' profits.

How the policy works

The policy is individual disability coverage designed for a buy-sell. The insured owner has a defined elimination period, the waiting time before benefits are payable. It is usually long, often a year or more depending on the carrier and the buy-sell terms, because the point is to fund a permanent change of ownership rather than replace paychecks. Group long-term disability and individual income policies (see group short- and long-term disability insurance for employers) handle the short and medium term.

Benefits are generally paid either as a lump sum after the elimination period or as installments over a period. Which forms are available is a carrier-specific design feature, and the buy-sell terms should match it. Benefit amounts are tied to the value of the ownership interest being funded, so the underwriter will ask for a valuation formula or a recent appraisal. Policy forms and definitions vary by insurer, so read the specimen policy rather than a marketing summary.

Cross-purchase or entity ownership

As with life funding, the structure follows the buy-sell. See cross-purchase vs entity redemption buy-sell plans for the full comparison.

• Cross-purchase: each owner buys a policy on every other owner. In a three-owner company that is six policies. The healthy owners receive the benefit and use it to buy the disabled owner's shares directly.
• Entity redemption: the company owns and pays for a policy on each owner and uses the proceeds to redeem the disabled owner's interest.

Owners often prefer the cross-purchase structure for disability because the buyers receive the benefit and end up with a basis in the shares they buy. Entity plans are easier to administer when there are many owners. The tax consequences differ and the entity type matters, so settle this with a CPA before the application.

The definition of disability must match

This is where buy-sell disability plans fail. The agreement defines the event that lets the owners buy. The policy defines the event that makes the insurer pay. If those definitions differ, the owners can be forced to buy without funding, or the insurer can decline a claim the agreement treats as a trigger.

Check these points in both documents:

1. Own-occupation versus any-occupation: does disability mean unable to do the owner's own work, or unable to do any work? The policy's wording controls payment.
2. Elimination period: the agreement should not require a purchase before the policy pays.
3. Partial disability: many buy-out policies pay only for total disability. A partially disabled owner may be neither bought out nor insured.
4. Recurrent disability: how a return to work and a later relapse are treated.
5. Price and timing: the purchase price per the buy-sell formula, a deadline to close after the trigger, and what happens to any shortfall or excess.
6. Option versus obligation: many agreements give the healthy owners an option to buy, not an obligation. Say which, and make sure the insurer knows.

Tax treatment, in outline

Disability benefit taxation turns on who paid the premium and how. Under IRC 104(a)(3), amounts received through accident and health insurance are generally excluded from income when the premiums were paid with after-tax dollars rather than deducted or paid by an employer on a tax-free basis. In a cross-purchase plan where each owner pays premiums personally, the benefits would then generally be received tax-free, and the premiums are not deductible. Entity-owned plans raise more questions, including how premiums paid by a corporation for owner-employees are treated. These are CPA questions, and the structure should be settled before the policy is bought.

Underwriting a disability buy-out policy

Disability underwriting differs from life underwriting because the insurer looks at occupation, earnings and the ownership interest, not only health. Expect these items:

• Medical history, including musculoskeletal, mental health and cardiac conditions, which often lead to exclusions or declines.
• Occupation class and duties, because a surgeon and a bookkeeper present different risks.
• Financial documentation, including tax returns and business financials, to show the insured amount is reasonable relative to the interest being purchased.
• A copy of the executed buy-sell agreement or a term sheet. Insurers want proof that a plan is in place and that the business will use the money for the purchase.

For an employee whose loss would hurt the business but who is not a buy-sell party, see key person disability insurance: protecting the business when a leader cannot work. For ongoing fixed expenses during a disability, see business overhead expense insurance: what it pays when an owner is disabled. For death funding, see Funding a buy-sell agreement with life insurance after Connelly.

Hypothetical example

Say two equal owners of a surveying firm each hold an interest worth $1.2 million by the buy-sell formula. They use a cross-purchase plan, each buying a disability buy-out policy on the other. Owner A is disabled by an illness. The agreement defines total disability as inability to perform the material duties of the insured's occupation for 12 consecutive months, matching the policy's elimination period. At the end of that period the policy pays Owner B, who uses it to buy A's shares under the agreement. Had the agreement used a six-month trigger, Owner B would have faced a purchase obligation six months before the money arrived. The numbers are invented for illustration. The buy-sell agreement funding calculator helps model funding against your own valuation.

Review checklist

• Does the buy-sell name disability as a triggering event, with a definition that matches the policy?
• Is the policy's elimination period no longer than the agreement's waiting period?
• Are coverage amounts updated when the business value changes?
• Who owns each policy, and who is the beneficiary?
• What happens to the policy if an owner leaves or the agreement is terminated?

Key takeaways

• A life-insurance-funded buy-sell does not pay if an owner is disabled; a disability buy-out policy fills that gap.
• Elimination periods are long, so the buy-sell trigger and the policy definition must line up exactly.
• Cross-purchase and entity structures both work; the right one depends on the number of owners and tax advice.
• Benefits are generally tax-free when premiums are paid with after-tax dollars, but confirm your structure with a CPA.
• Insurers underwrite occupation, health and financial justification, so bring the signed buy-sell to the application.