5.6 Business Disability: Overhead Expense, Buy-Sell & Key Person

Three Business Problems, Three Policies

When an owner or a critical employee becomes disabled, a business faces three separate exposures. The content outline names a distinct product for each, and the fastest way to keep them straight is to ask who is hurt and what does the money replace?

None of them replaces the disabled person's personal income. That is the job of individual disability income insurance, and the exam frequently offers "the owner's salary" as a distractor on BOE questions.

Business Overhead Expense

BOE keeps the doors open. It is designed for small professional practices — a dentist, an accountant, a two-attorney firm — where the owner's presence generates essentially all revenue but the fixed costs keep running.

Covered expenses typically include rent or mortgage interest, utilities, telephone and internet, employee salaries and payroll taxes, property and liability insurance premiums, equipment leases, depreciation, accounting and legal fees, and professional dues.

Not covered: the disabled owner's own salary or draw, the salary of anyone hired to perform the owner's duties, and the cost of inventory or goods.

Mechanics to memorize:

• BOE is reimbursement coverage: it pays actual covered expenses up to the monthly maximum. If the policy limit is $12,000 a month and actual expenses are $9,000, it pays $9,000.
• Many policies allow carry-forward of unused monthly benefit into later months of the same claim.
• Benefit periods are short, commonly 12 to 24 months — long enough to recover or to sell or wind down the practice.
• Elimination periods are short, because the bills arrive immediately.

Taxation: BOE premiums are deductible to the business as an ordinary business expense. Benefits are taxable income to the business — but because they are spent on deductible operating expenses, the net tax effect is usually a wash. That premium-deductible / benefit-taxable pairing is the exact opposite of buy-sell and key person, which is why the exam pairs them.

Disability Buy-Sell

A buy-sell agreement obligates the remaining owners, or the business itself, to purchase the interest of an owner who dies or becomes totally disabled. Disability buy-sell insurance funds the disability trigger.

• The agreement may be cross-purchase (each owner buys a policy on the others) or entity purchase / stock redemption (the business owns the policies).
• The benefit is usually a lump sum, sometimes paid in installments, and is sized to the agreed valuation of the ownership interest.
• The elimination period is long — commonly 12 to 24 months — because no one should be bought out over a broken leg. The parties want reasonable certainty that the disability is permanent before ownership changes hands.
• The policy defines disability strictly, often requiring total and presumably permanent inability to perform the duties of the owner's occupation in that business.

Taxation: premiums are not deductible — buying out an owner is a capital transaction, not a business expense — and the benefit is received income-tax-free by the purchasing party.

Key Person Disability

A key person is an employee whose skills, relationships, or knowledge materially drive revenue: a lead engineer, a top producer, a founder-CEO. The business has an insurable interest in that person's continued health.

• The business is the applicant, owner, premium payer, and beneficiary. The employee must consent and is the insured.
• Benefits fund the cost of recruiting, hiring, and training a replacement and cushion lost revenue during the transition.
• Taxation: premiums are not deductible, and benefits are received income-tax-free by the business — the same treatment as buy-sell, and easy to remember as "no deduction going in, no tax coming out."

Worked example

Dr. Nadia Osei owns a solo dental practice with $11,000 in monthly fixed overhead and takes a $16,000 monthly draw. She has an individual DI policy with a $9,000 monthly benefit and a BOE policy with a $12,000 monthly maximum, both with 60-day elimination periods.

She is disabled for eight months. After the elimination period, the BOE policy reimburses $11,000 a month — actual expenses, not the $12,000 limit — keeping the practice staffed and open. The individual DI policy pays $9,000 a month toward her personal income, tax-free because she paid the premium with after-tax dollars. Her personal shortfall is $7,000 a month against her prior draw; her practice's shortfall is zero. If she had bought only a larger individual DI policy, the practice would have closed within weeks, and no amount of personal benefit would have restored the patient base.