14.3 Business Disability (Key Person, Buy-Sell, Business Overhead)
Key Takeaways
- Key person DI is owned by the business to offset the economic loss of a disabled key employee; premiums are not deductible and benefits are tax-free.
- Disability buy-sell funds the purchase of a disabled owner's interest and uses a long elimination period (12-24 months) to confirm permanence.
- Business overhead expense reimburses fixed business expenses (rent, staff salaries, utilities) but never the owner's own salary.
- BOE is the tax exception: premiums are deductible and benefits are taxable, the reverse of key person and buy-sell.
- The universal rule: if premiums were after-tax, benefits are tax-free; if premiums were deducted, benefits are taxable.
Why Businesses Buy Disability Coverage
Individual DI replaces an employee's paycheck, but businesses face separate exposures when an owner or key employee becomes disabled: lost productivity, frozen ownership transitions, and ongoing fixed expenses. The exam tests three distinct business DI products, each solving a different problem. Confusing who owns the policy, who pays the benefit to whom, and how benefits are taxed is the most common error.
The Three Business DI Products
| Product | Problem solved | Policyowner / payee |
|---|---|---|
| Key person DI | Lost value of a disabled key employee | Business owns, pays premium, receives benefit |
| Disability buy-sell | Funding the buyout of a disabled owner | Business or co-owners; benefit funds purchase |
| Business overhead expense (BOE) | Keeping the doors open during owner disability | Business owns; reimburses actual expenses |
Key Person Disability Insurance
Key person DI protects the business against the economic loss caused by the disability of an essential employee — a top salesperson, a founder, a lead engineer. The business is the applicant, owner, premium payer, and beneficiary. Benefits give the firm cash to recruit and train a replacement, offset lost revenue, or reassure creditors.
Tax treatment: Premiums are not tax-deductible to the business (they are a capital-type expense protecting the business), and the benefits are received income-tax-free. This mirrors the key person life rule.
Disability Buy-Sell Insurance
A buy-sell agreement is a contract that commits surviving/active owners (or the business) to buy a departing owner's share and the disabled owner to sell. Disability buy-sell insurance funds that purchase when an owner becomes totally disabled. Key features:
- A long elimination period (often 12-24 months) confirms the disability is permanent before triggering a buyout.
- Benefits are typically paid as a lump sum or installments to fund the purchase price.
- Premiums are not deductible; benefits are received tax-free. The purchasing party gets a stepped-up basis in the acquired interest.
Business Overhead Expense (BOE)
Business overhead expense (BOE) insurance reimburses the fixed business expenses of a small business or professional practice when the owner is disabled — so the practice survives until the owner returns or the business is sold. It is a reimbursement contract: it pays actual covered expenses, not a flat benefit.
Covered expenses include: rent or mortgage interest, utilities, employee salaries (non-owner), property taxes, equipment leases, accounting and legal fees, insurance premiums, and depreciation.
NOT covered: the disabled owner's own salary or draw (that is what personal DI is for) and the cost of goods/inventory.
Tax treatment — the BOE exception: Premiums ARE tax-deductible as a business expense, but benefits are taxable to the business (offset by the deductible expenses they reimburse). This is the opposite of key person and buy-sell — a classic exam trap.
Worked Reimbursement Example
A dentist's BOE policy has a $15,000 monthly maximum. In a given month the practice incurs $11,000 of covered overhead. BOE pays $11,000 (actual expenses, not the $15,000 cap). If covered expenses were $18,000, BOE pays only the $15,000 maximum; the $3,000 excess is the practice's responsibility. Many BOE policies let unused monthly maximums carry forward to cover higher-expense months later in the benefit period.
Side-by-Side Tax Summary
| Coverage | Premiums deductible? | Benefits taxable? |
|---|---|---|
| Key person DI | No | No |
| Disability buy-sell | No | No |
| Business overhead expense | Yes | Yes |
| Personal individual DI (insured pays) | No | No |
| Group LTD (employer pays premium) | Yes (to employer) | Yes (to employee) |
Memory hook: The taxation of any disability benefit follows the premium. If premiums were paid with after-tax dollars (no deduction), benefits are tax-free; if premiums were deducted (pre-tax), benefits are taxable. BOE and employer-paid group LTD deduct premiums, so their benefits are taxed.
Why the Difference Makes Sense
The logic is that money should be taxed once. Key person and disability buy-sell premiums are paid from the firm's after-tax profits (no deduction), so the offsetting benefit comes back tax-free. BOE premiums are deductible because they pay ordinary, recurring business costs — but the reimbursement is then included in income, where it is offset by the deductible expenses it covers, producing a near wash. A common exam scenario asks you to identify which product gives the business an immediate premium deduction; the answer is always BOE, never key person or buy-sell.
A medical practice's business overhead expense (BOE) policy carries a $15,000 monthly maximum. In one month the practice incurs $11,000 of covered overhead expenses. How much does the BOE policy pay, and how are premiums/benefits taxed?
Which business disability product is designed to fund the purchase of a disabled owner's ownership interest and typically uses a long (12-24 month) elimination period?
Business Overhead Expense Insurance
Business Overhead Expense (BOE) insurance reimburses a disabled business owner for fixed business expenses — rent, utilities, employee salaries, lease payments — so the practice survives during recovery. It does not replace the owner's personal income (that is individual DI). Benefits are limited to actual covered expenses with a relatively short benefit period (often 1-2 years). BOE premiums are tax-deductible to the business, and benefits are taxable but offset by the deductible expenses they reimburse.
Key Person and Disability Buy-Sell
Key person disability insurance pays the business when an essential employee becomes disabled, covering lost revenue and the cost of finding a replacement. A disability buy-sell policy funds the buyout of a disabled owner's interest by the other owners or the entity, usually after a long elimination period (often 12+ months) with a lump-sum or installment payout. Distinguish these from BOE: key person and buy-sell address ownership and revenue; BOE pays ongoing office bills.
A disabled dental practice owner needs to keep paying office rent, staff salaries, and utilities during recovery. The appropriate coverage is: