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

Business Uses of Disability Insurance

Disability can cripple a business just as it can cripple a household. Three business DI products dominate the exam: key person (key employee) disability, disability buy-sell, and business overhead expense (BOE). Each answers a different question: who is paid, what triggers payment, and how the benefit is taxed. Confusing these is the most common business-DI error, so anchor each product to its purpose before memorizing the tax treatment.

Unlike personal DI, business DI premiums and benefits often run through the business entity, which changes both the application logic (the business may be applicant, owner, and beneficiary) and the tax outcomes covered in section 10.4.

Key Person Disability Insurance

Key person DI protects the business against the economic loss caused when a valuable employee (a top salesperson, founder, or technical lead) becomes disabled and can no longer contribute. The business is the applicant, premium payer, owner, and beneficiary; the key employee is the insured.

The benefit reimburses the firm for lost revenue and the cost of finding and training a replacement. It is usually a lump sum or a short benefit stream (one to two years) rather than a to-age-65 income, because the goal is to bridge the transition, not to support the employee personally.

Tax pattern to memorize: premiums are not deductible by the business, and the benefit received by the business is tax-free. This mirrors key person life insurance and is a frequent exam pairing.

Underwriting for key person DI looks at the employee's contribution to revenue, not just salary, and the insurable amount is justified by financial documentation showing the firm's exposure. Because the benefit goes to the business rather than the employee, key person coverage does not replace the disabled employee's personal income; that gap is filled separately by individual or group DI on the employee.

Disability Buy-Sell Insurance

A buy-sell agreement is a contract among business owners requiring the disabled owner's interest to be purchased by the remaining owners or the entity upon a triggering event. Disability buy-sell insurance funds that purchase when an owner becomes permanently disabled.

Key design features:

• A long elimination period is typical, often one to two years, because owners want certainty the disability is permanent before forcing a buyout.
• The benefit is usually a lump sum or installment payout equal to the agreed purchase price of the owner's share.
• The agreement structure may be cross-purchase (owners buy each other's shares) or entity (stock-redemption) (the business buys the share).

Tax pattern: premiums are not deductible, and benefits are received income-tax-free. The funds are used to buy out an ownership interest, a capital transaction, not to replace income.

The long elimination period is the defining exam feature here. Because forcing a buyout is irreversible, owners do not want to trigger the purchase over a temporary disability, so a one-to-two-year wait confirms permanence before the policy funds the transaction. Contrast this with personal DI, where insureds want benefits quickly and choose short elimination periods. A buy-sell policy without adequate funding leaves the healthy owners scrambling to find cash or borrow to buy out the disabled partner, which is exactly the risk the coverage removes.

Business Overhead Expense (BOE) Insurance

BOE insurance reimburses a disabled owner for the ongoing fixed business expenses that continue while the owner cannot work, so the business stays open until the owner recovers or winds down. It is essential for small professional practices (dentists, physicians, attorneys) where the owner generates most revenue.

Covered vs. Not Covered Under BOE

BOE features a short benefit period (commonly 12 to 24 months) and a short elimination period (30 to 90 days), since bills come due quickly. Benefits are limited to actual expenses incurred, up to the policy maximum, so it is a reimbursement contract.

Tax pattern (the BOE exception): premiums are tax-deductible as a business expense, but benefits are taxable as income to the business. This is the reverse of key person and buy-sell, and it is the single most tested business-DI tax fact.

Three Business Disability Uses

Mechanics and Taxation

Key person DI premiums are not deductible, and benefits are received tax-free by the business. Buy-sell funding uses a longer elimination period (often 1-2 years) because a buyout should not trigger on short disabilities; benefits fund the purchase price under a pre-set agreement. BOE premiums are deductible as a business expense, and benefits are taxable — but they reimburse deductible overhead, so the net effect washes out.

Worked Example (BOE): A dentist with $18,000/month overhead and a BOE policy capped at $15,000/month who becomes disabled receives up to $15,000/month to keep the office running while she recovers — reimbursing actual expenses, not lost personal income. BOE typically pays only for a short maximum (e.g., 12-24 months), long enough to recover or sell the practice.

Exam Distinction: BOE replaces business expenses; individual DI replaces personal income; key person DI offsets the firm's lost earnings from a missing employee.