10.3 Business Disability (Key Person, Buy-Sell, BOE)

Disability Insurance for the Business

Beyond individual income replacement, the exam tests three business uses of disability insurance. Each answers a different business need, and confusing them is a common error. The quick map:

The outlier is BOE: it is the one business DI plan whose premiums are tax-deductible as a business expense, and consequently its benefits are taxable. Key person and buy-sell premiums are not deductible, so their benefits are received tax-free.

Key Person Disability Insurance

A business depends on certain employees whose disability would cause real financial loss — lost sales, the cost of hiring and training a replacement, or disruption to operations. Key person DI lets the business insure against that loss. The business applies for the policy, pays the premium, owns the policy, and is the beneficiary; the key employee is the insured and must consent.

Because the business cannot deduct the premium (it is protecting itself, akin to insuring its own profits), the benefit it receives is tax-free. Benefits are intended to fund a replacement and offset lost revenue, not to pay the disabled employee's salary — though the employer may choose to use the funds for severance or salary continuation.

Key person DI typically carries a moderate elimination period and a benefit period long enough to recruit and onboard a successor — often one to two years. The amount of coverage is justified during underwriting by the employee's contribution to revenue or profits, not by a flat formula. A common distractor on the exam claims the employee is the beneficiary; remember that in key person coverage the business is both owner and beneficiary, and the employee merely consents to being insured.

Disability Buy-Sell Insurance

A buy-sell agreement obligates remaining owners (or the business) to buy out an owner's interest upon a triggering event. Life insurance funds the death trigger; disability buy-sell funds the permanent disability trigger. Without it, a disabled owner could continue to draw from the business while contributing nothing, straining the surviving owners.

Key exam points:

• The elimination period is long — commonly 12, 18, or 24 months — because the buyout should occur only after a disability is clearly permanent, not after a temporary absence.
• Benefits may be paid as a lump sum or in installments to fund the purchase price.
• Premiums are not deductible; the buyout proceeds are received tax-free.
• It funds a transfer of ownership, not income replacement, which distinguishes it from individual DI and BOE.

The funding mechanism matters on the exam: in an entity (stock-redemption) plan the business owns the policies and buys the disabled owner’s share, while in a cross-purchase plan each owner insures the others. Either way, a written buy-sell agreement must set a valuation method (fixed price, formula, or appraisal) so the disability proceeds match the agreed purchase price. The long elimination period and the requirement of a permanent, total disability prevent a temporary illness from forcing a premature and irreversible ownership transfer.

Business Overhead Expense (BOE) Insurance

BOE reimburses a small business owner — often a professional such as a physician, dentist, or attorney — for the fixed business expenses that continue while the owner is disabled. Covered expenses include rent or mortgage interest, utilities, employee salaries (non-owner), leasing costs, accounting fees, and depreciation. It does not reimburse the owner's own salary or draw — that is what individual DI is for.

BOE characteristics tested on the exam:

• Short elimination period (often 15-30 days) and a short benefit period (commonly 1-2 years) — just long enough to keep the practice open or arrange an orderly sale.
• Reimbursement is for actual covered expenses incurred, up to the monthly maximum, so it functions on a reimbursement (not valued) basis.
• Premiums are tax-deductible as a business expense; therefore benefits are taxable income to the business.

Worked example: A dentist's BOE policy carries a $9,000 monthly maximum. In a given month her covered overhead is $7,500. BOE reimburses the lesser of actual expenses or the maximum, so she receives $7,500, not $9,000. If a later month's overhead reaches $10,000, she receives only the $9,000 cap.

Many BOE contracts add a carry-forward feature: if covered expenses in one month fall below the monthly maximum, the unused amount can be applied to a later month when expenses exceed the cap, subject to the aggregate benefit period. This smooths reimbursement for practices with uneven monthly costs. Because BOE benefits are taxable to the business but the reimbursed expenses are themselves deductible, the two largely offset on the practice's return — a point the exam may test as a reason the taxable-benefit treatment is not as punitive as it first appears.