14.3 Business Disability (Key Person, Buy-Sell, Business Overhead)
Key Takeaways
- Key person disability insurance reimburses the business for losses when a vital employee becomes disabled; the business owns the policy and is the beneficiary.
- Disability buy-sell insurance funds the purchase of a disabled owner's share under a buy-sell agreement.
- Business overhead expense (BOE) insurance reimburses fixed operating costs, not owner income, during the owner's disability.
- BOE benefits are taxable to the business but the reimbursed expenses are deductible, netting roughly even.
- Buy-sell DI uses a long elimination period because share buyouts are not made over short disabilities.
Disability does not only threaten an individual's paycheck; it can cripple a business. Three distinct products address business exposures, and the exam expects you to know who owns each policy, who is insured, who receives benefits, and how benefits are taxed.
Key Person Disability Insurance
Key person disability insurance protects the business against the economic loss caused when an essential employee, such as a top salesperson, founder, or specialized engineer, becomes disabled. The disability of a key person can mean lost revenue, the cost of finding and training a replacement, and lost customer confidence.
| Element | Key person DI |
|---|---|
| Policy owner | The business |
| Premium payer | The business |
| Insured | The key employee |
| Beneficiary | The business |
| Premium deductible? | No |
| Benefits taxable? | No (received tax-free) |
Exam trap: Key person premiums are NOT deductible, and the benefits the business collects are tax-free. The business cannot deduct a cost incurred to protect its own profits.
Disability Buy-Sell Insurance
A buy-sell agreement is a binding contract that obligates the remaining owners (or the business) to buy a departing owner's interest upon a triggering event. Death is funded with life insurance; total disability is funded with disability buy-sell insurance.
How It Funds the Buyout
When an owner becomes totally and permanently disabled, the policy provides cash, often as a lump sum or installments, that the buyers use to purchase the disabled owner's share at the agreed price.
| Element | Disability buy-sell |
|---|---|
| Purpose | Fund purchase of a disabled owner's interest |
| Elimination period | Long, commonly 12 to 24 months |
| Benefit form | Lump sum or installments |
| Premium deductible? | No |
| Benefits taxable? | No |
Why the long elimination period? Owners do not want to buy out a partner who may recover in a few months. The 12 to 24 month wait confirms the disability is genuinely permanent before triggering an irreversible ownership transfer.
Funding Structures
- Cross-purchase: each owner buys a policy on every other owner.
- Entity (stock-redemption): the business owns one policy on each owner.
With three or more owners, cross-purchase requires many policies (n x (n-1)), so the entity method is often simpler.
A crucial drafting point is that the buy-sell agreement and the funding policy must agree on the disability definition and the valuation price. If the agreement triggers a buyout at total and permanent disability but the policy uses a 24-month own-occupation standard, a dispute can arise over whether the trigger has been met. Producers should confirm the legal agreement and the insurance contract use compatible definitions and the same valuation method, whether a fixed price, a formula, or an appraisal.
Business Overhead Expense (BOE) Insurance
Business overhead expense (BOE) insurance reimburses the fixed operating costs a small business or professional practice incurs while the owner is disabled. It keeps the doors open so the business survives until the owner recovers or sells.
What BOE Covers and Excludes
| Covered fixed expenses | NOT covered |
|---|---|
| Rent or mortgage interest | The owner's salary or draw |
| Employee salaries | Owner profit |
| Utilities and phone | Inventory or merchandise |
| Equipment leases | New equipment purchases |
| Property taxes, insurance | Income lost by the owner |
BOE has a short elimination period (often 30 days) because rent and payroll come due quickly, and a short benefit period (commonly 12 to 24 months) because the business must reorganize, not be funded indefinitely.
Exam trap: BOE does NOT replace the owner's income. That is the job of an individual DI policy. BOE only pays the business's deductible operating expenses.
Taxation of Business DI
| Product | Premium deductible? | Benefit taxable? | Net effect |
|---|---|---|---|
| Key person DI | No | No | Business protects profit tax-free |
| Disability buy-sell | No | No | Clean funding of buyout |
| Business overhead expense | Yes | Yes | Roughly even because reimbursed expenses are deductible |
BOE Tax Example
A practice receives $20,000 in BOE benefits in a month and uses it to pay $20,000 of deductible rent and payroll. The $20,000 benefit is taxable income, but the $20,000 of expenses is deductible, so the net taxable effect is approximately zero.
| Item | Amount |
|---|---|
| BOE benefit received (taxable) | +$20,000 |
| Deductible expenses paid | -$20,000 |
| Net taxable income from BOE | $0 |
Quick Comparison
| Product | Protects | Elimination period | Benefit period |
|---|---|---|---|
| Key person | Lost productivity/revenue | Moderate | Short to moderate |
| Buy-sell | Ownership transfer | Long (12-24 mo) | Lump sum / installments |
| BOE | Fixed operating costs | Short (30 days) | Short (12-24 mo) |
A dental practice owner becomes disabled. Which coverage reimburses the practice's rent, staff payroll, and utilities, but NOT the dentist's own income?
Why do disability buy-sell policies use an elimination period of 12 to 24 months?