14.3 Business Disability (Key Person, Buy-Sell, Business Overhead)

Why Businesses Buy Disability Coverage

A disabling injury or illness to an owner or essential employee can damage a business as severely as a death. Three distinct business disability products address three distinct risks. The exam tests who owns the policy, who pays, who is the beneficiary, and how proceeds are taxed.

• Key person (key employee) disability protects the business against lost productivity and replacement costs when an essential employee is disabled.
• Disability buy-sell funds the purchase of a disabled owner's share of the business.
• Business overhead expense (BOE) keeps a small business's fixed expenses paid while the owner is disabled.

These are separate from personal DI and serve the business entity, not the individual's living expenses.

A recurring exam theme is that the purpose of each policy dictates its design. Productivity-loss products (key person, BOE) pay quickly with short elimination periods because business harm starts immediately. Ownership-transfer products (buy-sell) wait a long time because they trigger an irreversible sale. Keep the taxation rule attached to each purpose: only BOE, which funds ordinary deductible business expenses, has deductible premiums and taxable benefits.

Key Person Disability

In key person disability insurance, the business is the applicant, owner, premium payer, and beneficiary; the key employee is the insured. The benefit reimburses the company for losses caused by the employee's absence: hiring and training a replacement, lost sales, and disrupted financing.

• Premiums are NOT tax-deductible to the business (it is protecting its own interest).
• Benefits are received income-tax-free by the business.
• Coverage requires the key person's consent and an insurable-interest justification.

This mirrors key person life insurance: nondeductible premiums, tax-free proceeds. The elimination period is usually short (30-90 days) because business disruption begins immediately.

Disability Buy-Sell

A buy-sell agreement is a contract among business owners requiring the disabled owner's interest to be sold to the remaining owners or the entity at a preset price. Disability buy-sell insurance funds that purchase so the healthy owners are not forced to find cash or take on a non-working partner.

Key mechanics:

• The elimination period is long - typically 12 to 24 months - because owners must be sure the disability is permanent before triggering a buyout.
• The benefit is usually a lump sum (or installments) equal to the business valuation, not a monthly income stream.
• Premiums are not deductible; benefits are tax-free. The proceeds become the buyer's cost basis in the acquired interest.

Structures parallel life buy-sell: cross-purchase (each owner insures the others) versus entity (stock-redemption) plan (the business owns the policies).

Business Overhead Expense (BOE)

Business overhead expense insurance reimburses a disabled owner's business for ongoing fixed operating costs so the doors stay open while the owner recovers. It does NOT replace the owner's salary - that is what personal DI does.

BOE is unique among business DI products in that premiums ARE tax-deductible as a business expense, and benefits are taxable - but they offset deductible business expenses, so the net tax effect is usually neutral. The benefit is capped at actual expenses incurred and paid monthly with a short elimination period.

Cross-Purchase vs Entity Structures and Valuation

Disability buy-sell agreements use the same two funding structures as life buy-sell, and the exam tests how policy ownership maps to each.

• Cross-purchase plan: Each owner buys and owns a disability policy on every other owner. With three owners this means six policies (each insures the other two). On a triggering disability, the surviving owners receive tax-free proceeds and buy the disabled owner's share, stepping up their basis.
• Entity (stock-redemption) plan: The business itself owns one policy per owner and redeems the disabled owner's interest. Simpler to administer with many owners, but the surviving owners get less basis step-up.

The valuation method must be stated in the agreement - fixed price, book value, or a formula such as a multiple of earnings - and reviewed regularly so the funding amount matches the buyout obligation. Underfunding leaves healthy owners scrambling for cash; overfunding wastes premium. A well-drafted buy-sell also fixes the value for estate-tax purposes.

Comparison Table and Scenario

Scenario: Dr. Lin owns a dental practice with $18,000/month in rent, staff payroll, and utilities. She is disabled for 8 months. Her BOE policy reimburses up to $18,000/month of those documented fixed costs, keeping the practice open and staff employed. Her personal DI separately replaces her own income. If she had a buy-sell-only need, that product would not pay these monthly bills.