14.3 Business Disability (Key Person, Buy-Sell, Business Overhead)
Key Takeaways
- Key person DI insures the business against lost productivity when a vital employee is disabled; the business owns, pays for, and receives the benefit.
- Disability buy-sell funds the purchase of a disabled owner's interest, using a longer elimination period (often 12-24 months) and usually a lump-sum or installment payout.
- Business overhead expense (BOE) reimburses fixed business operating costs while a disabled owner cannot work; it does not pay the owner's salary.
- BOE benefits are limited to actual covered expenses and have short benefit periods (typically 1-2 years).
- Tax treatment differs by policy: BOE premiums are deductible and benefits taxable, while key person premiums are not deductible and benefits are received tax-free.
Key Person Disability Insurance
Key person (key employee) disability protects a business from the financial loss caused when an essential employee, such as a top salesperson or technical founder, becomes disabled. The disability of that person can stall revenue, projects, and lender confidence.
The ownership structure is the testable point:
| Role | Party |
|---|---|
| Policyowner | The business |
| Premium payer | The business |
| Insured | The key employee |
| Benefit recipient | The business |
Because the business is protecting its own balance sheet, premiums are NOT tax-deductible, and the benefits are received income-tax-free. The funds help cover lost profits, the cost of finding and training a replacement, and reassurance to creditors. Benefit amounts are based on the employee's economic value to the firm, not a percentage of personal income.
The logic mirrors key person LIFE insurance: the business cannot deduct the premium because it would otherwise gain a tax-favored windfall, so in exchange the benefit comes back tax-free. On the exam, remember that key person coverage exists to indemnify the EMPLOYER, which is why the employer is owner, payer, and beneficiary all at once.
Disability Buy-Sell Insurance
A buy-sell agreement is a contract among co-owners that requires the business or remaining owners to buy out an owner who dies or becomes disabled. Disability buy-sell insurance funds the buyout when an owner is totally disabled.
Distinct features versus ordinary DI:
- Long elimination period: Often 12 to 24 months, because owners want certainty the disability is permanent before triggering a buyout.
- Payout form: Usually a lump sum, or a lump sum after installments, sized to the agreed purchase price of the owner's interest, not monthly income replacement.
- Goal: Provide cash so the healthy owners can buy the disabled owner's share and the disabled owner (or family) receives fair value.
Tax Treatment
For disability buy-sell, premiums are not deductible and the benefit is received tax-free. The amount paid for the ownership interest is then treated under capital-gains rules at the time of sale.
Exam tip: A disability buy-sell uses a LONG elimination period (often 1-2 years) precisely because triggering a permanent ownership transfer over a short, recoverable disability would be a mistake.
Cross-Purchase vs Entity Structure
Like its life-insurance counterpart, a disability buy-sell can be structured two ways. In a cross-purchase arrangement, each owner buys a policy on the other owners, and surviving owners use the proceeds to buy the disabled owner's share. In an entity (stock-redemption) arrangement, the business itself owns the policies and redeems the disabled owner's interest. The choice affects the number of policies needed (cross-purchase requires more as the number of owners grows) and the cost basis of the surviving owners' interests.
Business Overhead Expense (BOE)
Business Overhead Expense (BOE) insurance reimburses the ongoing fixed costs of running a business while the owner is disabled and unable to generate revenue. It keeps the practice or shop operating until the owner recovers or winds down.
Covered vs Not Covered
| Covered Expenses | Not Covered |
|---|---|
| Rent or mortgage interest | The disabled owner's own salary or draw |
| Employee salaries | The owner's lost profits |
| Utilities and telephone | New equipment purchases |
| Equipment leases and depreciation | Income of a replacement professional beyond stated limits |
| Property taxes, insurance premiums, accounting fees |
Key mechanics: BOE is a reimbursement contract. It pays the LESSER of actual covered monthly expenses or the policy maximum, so it never overpays. Elimination periods are short (often 30-90 days) and benefit periods are short, typically 1 to 2 years, because overhead protection is meant to bridge a temporary gap.
Tax Treatment
BOE is the opposite of key person: premiums ARE tax-deductible as a business expense, and benefits ARE taxable income (offset by the deductible expenses they reimburse, so the net effect is usually neutral).
The symmetry is the memory hook. Because the employer DEDUCTS the premium, the system recaptures the tax by making the benefit taxable; because key person and buy-sell premiums are NOT deductible, those benefits are tax-free. The same deduct-now-tax-later versus pay-now-receive-free trade-off appears throughout insurance taxation, and BOE is the cleanest example to anchor it.
Worked Example
An architect's policy has a $9,000 monthly BOE maximum. During a disability, actual covered overhead is $7,200 one month and $10,500 another month. BOE pays $7,200 the first month (actual is lower) and $9,000 the second month (capped at the maximum).
A solo dentist becomes disabled. He wants a policy that will reimburse his office rent, staff salaries, and utilities while he cannot work, so the practice stays open. Which policy fits, and how are benefits limited?
Regarding income taxation of business disability coverage, which pairing is correct?