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

Why Businesses Buy Disability Coverage

When an owner or essential employee becomes disabled, the firm faces lost revenue, replacement-hiring costs, and continuing fixed expenses. Three distinct products address these risks. The exam tests who owns the policy, what the benefit pays for, and how the premium and benefit are taxed.

Key Person Disability Insurance

The firm insures a vital employee whose disability would damage earnings. The business is owner, premium payer, and beneficiary.

• Benefits help cover lost profit, hiring and training a replacement, and reassuring creditors.
• Benefits are usually paid as a lump sum or short benefit stream after a long elimination period (often 60-90 days), because the need is transitional.
• Premiums are not tax-deductible to the business (they protect the firm's own interest), so the benefits are received income-tax-free.

The consent and insurable-interest requirements parallel key-person life insurance: the employee must consent and the firm must show a genuine financial stake.

Key Person: Worked Sizing Example

A firm earns $600,000 of annual net profit, of which a key engineer drives an estimated 40%. The firm expects 18 months to recruit and train a replacement.

The insurer translates this into a monthly benefit and benefit period; the goal is to bridge the firm's earnings gap, not to replace the employee's personal income.

Disability Buy-Sell Insurance

A buy-sell agreement obligates the remaining owners (cross-purchase) or the entity (entity/stock-redemption) to buy out an owner who becomes totally disabled. Disability buy-sell insurance funds that purchase with cash instead of forcing a fire sale or loan.

Key mechanics:

• A long elimination period (commonly 12-24 months) confirms the disability is permanent before triggering a buyout.
• The benefit is paid as a lump sum or installments matching the agreement's purchase terms.
• Premiums are not deductible; benefits are tax-free. The disabled owner's later gain on the sale is a capital transaction, separate from the insurance benefit.

Business Overhead Expense (BOE)

Business Overhead Expense (BOE) insurance reimburses the ongoing fixed costs of running a small business or professional practice while the owner is disabled, so the doors stay open.

Covered expenses typically include:

• Rent or mortgage interest, utilities, property taxes
• Employee salaries (non-owner) and payroll taxes
• Leased equipment, insurance premiums, accounting and legal fees

BOE does not reimburse the disabled owner's own salary or draw, inventory, or profit. Benefits are reimbursement-based: the policy pays the lesser of the monthly maximum or actual expenses incurred. Elimination periods are short (often 30 days) and benefit periods are short (12-24 months).

Worked Example: BOE Reimbursement Cap

A dentist's BOE policy has a $12,000 monthly maximum. During a disability month her actual covered overhead is:

Because BOE pays the lesser of the $12,000 maximum or actual covered expenses, she is reimbursed $10,700, not $12,000. Her personal salary is excluded; she would cover that with a separate individual DI policy. Some contracts let unused monthly amounts carry forward to higher-expense months.

Tax Treatment Summary

The deductibility rule is consistent: a premium is deductible only when its benefit would be taxable.

BOE is the exception: because it reimburses ordinary, deductible business expenses, the premium is deductible and the benefit is taxable, but the taxable benefit is offset by the deductible expenses it pays, leaving little net tax. Key person and buy-sell premiums protect the firm's own capital, so they are non-deductible and their benefits are tax-free.