14.3 Business Disability (Key Person, Buy-Sell, Business Overhead)
Key Takeaways
- Key person DI is owned by and paid to the business to offset losing a vital employee; premiums are nondeductible so benefits are tax-free.
- Disability buy-sell funds the purchase of a disabled owner's interest, uses a long 12–24 month elimination period, and pays tax-free because it buys a capital asset.
- Business Overhead Expense reimburses fixed operating costs (not the owner's salary); its premiums are deductible, so reimbursements are taxable to the business.
- BOE is a reimbursement contract paying the lesser of actual covered overhead or the monthly maximum, capped over a stated benefit period.
Why Businesses Buy Disability Coverage
A disabled owner or essential employee can damage a business as badly as a death. Business disability insurance addresses three distinct risks: losing the productivity of a vital person (key person DI), funding the purchase of a disabled owner's interest (disability buy-sell), and keeping the lights on during an owner's disability (business overhead expense). The national exam tests who owns each policy, who pays premiums, who receives benefits, and how each benefit is taxed.
Comparison of the Three Business DI Products
| Feature | Key Person DI | Disability Buy-Sell | Business Overhead Expense (BOE) |
|---|---|---|---|
| Purpose | Replace lost revenue / cost of replacing a vital employee | Fund buyout of a disabled owner's share | Pay fixed business operating costs |
| Owner/payer of policy | Business | Business or co-owners (per agreement) | Business |
| Insured | Key employee | Each owner | Owner(s) |
| Benefit paid to | Business | Buyer (to purchase the interest) | Business |
| Premium deductible? | No | No | Yes (ordinary business expense) |
| Benefits taxable? | No (premiums not deductible) | No (treated as purchase of capital asset) | Yes (premiums were deducted) |
| Elimination period | Short to moderate | Long (12–24 months) to confirm permanence | Short (30–90 days) |
The recurring exam pattern: BOE premiums are deductible, so its benefits are taxable; key person and buy-sell premiums are not deductible, so their benefits are not taxable.
Key Person Disability Income
A business depends on certain employees, a top salesperson, a lead engineer, a founder, whose disability would reduce revenue or force costly replacement. The business owns the policy, pays the premium, and receives the benefit to offset lost profits and hiring/training costs.
Key points:
- The business, not the employee, is the beneficiary.
- Premiums are not deductible (the business protects itself), so benefits are received tax-free.
- Benefits are typically a lump sum or limited monthly payments for a relatively short period, long enough to recover or replace the person.
- Insurable interest must exist at issue: the business must show genuine economic dependence on the key person.
Disability Buy-Sell Insurance
A buy-sell agreement is a contract among co-owners specifying that, on a triggering event, the remaining owners (or the business) will buy the affected owner's interest at a set price. Disability buy-sell insurance funds that purchase when an owner becomes totally disabled.
Mechanics:
- A long elimination period (commonly 12–24 months) confirms the disability is permanent before triggering a buyout, avoiding a forced sale over a temporary disability.
- Benefits may be paid as a lump sum, in installments, or a combination, matching the agreement's funding plan.
- Because the benefit funds the purchase of a capital asset (an ownership interest), benefits are received tax-free, and premiums are not deductible.
- The two structures mirror life buy-sell: cross-purchase (owners buy each other's shares) and entity (stock-redemption) (the business buys the share).
Why do disability buy-sell policies typically use a long elimination period of 12 to 24 months?
Business Overhead Expense (BOE)
Business Overhead Expense insurance reimburses the fixed operating costs of a business while the owner is disabled, so the business stays open. It is most valuable for small professional practices (dentists, attorneys, accountants) that depend on one or two producers.
Covered overhead typically includes:
- Rent or mortgage interest, utilities, property taxes
- Employee salaries (of non-owners), payroll taxes, benefits
- Equipment leases, insurance premiums, accounting/legal fees
Not covered: the disabled owner's own salary or draw, and costs incurred only because the owner is absent (e.g., a substitute professional's fee, unless added by rider).
Tax treatment: BOE premiums are a deductible business expense, so reimbursements are taxable income to the business, though they are typically offset by the deductible expenses they reimburse.
BOE Reimbursement Worked Example
A dental practice has $12,000/month in covered overhead and a BOE policy with a $10,000 monthly maximum and a 24-month maximum benefit period.
| Month's actual overhead | BOE reimbursement |
|---|---|
| $12,000 | $10,000 (capped at the monthly maximum) |
| $8,000 | $8,000 (BOE reimburses actual expenses, not the cap) |
| $10,500 | $10,000 (capped) |
BOE is a reimbursement contract: it pays the lesser of actual eligible overhead or the monthly maximum, never more than incurred. Unused monthly amounts may extend the benefit period in some contracts. Over 24 months the most this policy could pay is 24 × $10,000 = $240,000.
A practice's BOE policy has a $9,000 monthly maximum. In a month with $7,500 of covered overhead, how much does BOE reimburse?
Disability reducing the value of a business interest
The exam frames business DI around three distinct needs, and a common trap is matching the wrong product to a fact pattern. Key person DI indemnifies the business for lost productivity and the cost of replacing a disabled key employee; the business is owner, premium payer, and beneficiary, and benefits are received tax-free because premiums are not deductible.
Funding the buy-sell: entity vs. cross-purchase
A disability buy-sell funds the purchase of a disabled owner's share. It can be structured as an entity (stock-redemption) plan, where the business owns one policy per owner, or a cross-purchase plan, where each owner insures the others. Buy-sell benefits typically begin after a long elimination period (often 12-24 months), because partners want certainty the disability is permanent before triggering a buyout.
Business overhead expense limits
BOE reimburses fixed business expenses (rent, utilities, staff salaries, lease payments) — but not the owner's own salary — on a reimbursement basis up to a monthly cap, for a short benefit period (often 1-2 years). BOE benefits are taxable but the premiums are tax-deductible to the business, the reverse of key-person treatment.
A business overhead expense (BOE) disability policy reimburses which of the following when the owner is disabled?