The disability of business owners or key employees poses a serious risk to a business�s financial health. Just as a family suffers from the loss of the income of its breadwinners, a business suffers from the loss of its productive resources. The problems are particularly acute for small enterprises in which the work force may not be large enough to have a backup for critical skills that could be interrupted because of disabilities. Good examples of business owners in need of disability insurance are self-employed attorneys, accountants, physicians, and dentists who operate solo practices and employ a support staff of one or more persons. When these business owners become totally disabled, the primary business activities are often halted. However, it is necessary to maintain the business premises and at least a skeletal support staff so that business can be resumed when the business owner recovers from the disability. For example, accounts receivable must still be collected and ongoing expenses must still be paid.

Overhead expense policies are available to cover many of the ongoing costs of operating a business while the business owner is totally disabled. These policies tend to be limited to benefit durations of one or 2 years and have relatively short elimination periods. The intent is to keep the necessary staff and premises available for the resumption of business if the business owner recovers from the disability. However, if the disabled business owner has not recovered within the one- or 2-year benefit period, it is expected that the business will either be sold or terminated. There is a relatively low probability that an individual who has been disabled for 2 years will recover from the disability. For example, if the original onset of the individual�s disability was at age 35, the probability of recovery is 23 percent, based on 1964 Commissioners Disability Table figures. Likewise, if the onset of the disability was at age 45 and continues for 24 months, there is only a 15 percent likelihood of recovery. For individuals aged 55 sustaining 2 years of disability, only 8 percent are likely to recover. Consequently it is not unreasonable that business overhead expense policies limit benefit periods to a maximum of 24 months. Preliminary estimates based on the 1985 Individual Disability Table indicate that the probability of recovering has slipped even lower.

Insurance companies are extremely cautious in writing this coverage and in keeping the benefit amount in line with established stable costs for previous periods. Consequently the application for such coverage must be accompanied by supporting financial statements to verify the stability of the business and to establish the appropriate level of insurable expenses. These expenses include such things as salaries for secretaries, nurses, and other staff necessary to resume business upon the business owner�s recovery as well as the ongoing expenses for rent, utilities, taxes, accounting services, and so forth.

In most cases it would be impossible for the disabled individual to cover these ongoing business expenses through disability benefits payable under an ordinary disability income policy. Continuing the business through a disability of up to 2 years often depends on the existence of a business overhead policy. In the absence of such coverage the business owner must expend accumulated assets, such as savings and investments, to keep the business entity operational. Business overhead expense coverage provides a less painful method of meeting these ongoing business expenses. A business overhead policy greatly increases the likelihood of a business�s continuing after the business owner recovers from a serious disability. The business owner is best protected by a combination of appropriate business overhead expense coverage and a disability income policy for the replacement of lost personal income.

Business entities are dependent on their personnel to carry out their activities and generate revenues and profits. Very often there are a few key individuals whose unique talents and experiences are crucial to the success of the business entity. The loss of an individual�s contributions by reason of disability or death could deal a devastating blow to the financial well-being of the enterprise. In fact, sometimes the dependence is so critical that losing the individual�s participation could lead to the bankruptcy or termination of the business itself. This is particularly true of professionals operating as sole practitioners.

Many business enterprises have recognized the importance of key individuals who make the most critical contributions and have obtained disability income insurance covering these key individuals. The justification for such coverage is very similar to that for key person life insurance policies. Proceeds from key person disability policies can be used to replace lost revenue directly attributable to the key person�s disability, to fund the search for individuals to replace the insured person, to fund the extra cost of hiring specialized individuals to replace the multiple talents of the insured, and to fund training costs that may be incurred to prepare replacements to carry out the duties the insured performed. Some or all of these considerations may prompt enterprises to obtain key person disability policies. The motivation itself may help the business managers determine the appropriate amount of coverage to obtain. The costs of training, hiring, and compensating are usually rather easy to ascertain, while estimating lost revenue is a very difficult and complex task.

Even though a business entity may determine a desired amount of disability income protection for each key individual, it may not be able to obtain that amount of coverage. The underwriting processes of insurance companies limit the maximum amount of coverage available on any one individual. A wide range of guidelines is utilized for setting these limitations, and it is usually difficult to get an insurer to waive any of these limitations. Sometimes a business entity is able to make a strong enough argument on both financial and economic grounds to justify an exception and obtain the desired amount even though it exceeds underwriting guideline limitations.

Benefits from key employee disability policies are payable to the business entity when the insured key employee is disabled. The policies used for these purposes are usually the same as the group or individual disability income policies available to the general populace. They are subject to the same range of policy provisions already discussed with respect to definitions of disability, benefit periods, elimination periods, waiver of premium, renewal period, and other considerations.

Disability policies owned by the corporation or business entity with benefits payable to that entity are not deductible business expenses for federal income tax purposes. Payment of those premiums does not create a taxable income to the insured employee. Consequently the receipt of insurance proceeds under the policy by the business entity is not considered taxable income to the business.

Disability income policies can be purchased by the business entity to fund formal corporate salary continuation plans. Formal plans can be set up in two different ways. The corporation can own the policy and be the beneficiary under the policy, or the corporation can pay the premiums on a policy owned by the employee to whom benefits will be paid. When the corporation is the owner of the policy and the beneficiary, premium payments are nondeductible by the corporation and the corporation will receive the insurance proceeds free of any federal income tax liability. Premium payments for such coverage will not be considered taxable income to the employee.

When the corporation merely pays the premiums on a policy owned by the employee, the premiums are deductible expenses of the corporation as long as they meet reasonable expense criteria. The premium payments are not considered taxable income to the employee; however, benefits paid under the policy will be taxable income to the employee.

Sometimes informal salary continuation plans are set up where the corporation pays a large enough bonus to the employee for the employee to buy an individual disability income policy. If the bonus payments are reasonable compensation, they are deductible by the corporation. The bonus is taxable income to the employee. The premium payments made by the employee are not deductible. Any benefit payments received by the employee will have no effect on the corporation and will be received free of any federal income tax liability by the employee.

A business owner�s disability often threatens the viability of that enterprise. In order to preserve the value of the business it is often necessary to shift the business owner�s ownership interest to one or more other individuals who can continue conducting the affairs of the business. In cases in which there is multiple ownership of the business prior to the disability, the most likely parties to purchase the ownership interest of the disabled owner are the nondisabled co-owners. Unfortunately few business owners have adequate amounts of liquid assets to make an outright purchase of the ownership interest from the disabled co-owner.

Just as buy-sell agreements triggered by the death of an owner can be funded with life insurance, buy-sell agreements triggered by the disability of an owner can be funded with disability policies. Special disability policies have been designed specifically for the purpose of funding buy-sell agreements. These policies can fund either an installment purchase or a lump-sum buyout. It is now possible to obtain lump-sum coverage for amounts as high as $50 million for a single disability policy if the underwriting criteria are met. This is a relatively recent development within the disability insurance market.

The disability risk for business owners is just as real as the disability risk for other individuals. The same probabilities of occurrence apply. Any attorney drafting the necessary documents to establish a new business entity, whether it is a partnership or a corporation, would be considered negligent if he or she did not at least recommend buy-sell agreements covering both death and disability of the respective owners. These buy-sell agreements stipulate how the business ownership interests are to be transferred to the surviving or continuing owners upon the death or disability of one of them. In the case of a disability buyout, the agreement must stipulate what definition of disability is to be used and how long after the onset of the disability the ownership is to be sold to the nondisabled partners or co-owners. The agreement must further stipulate how and when the ownership interest is to be valued and on what conditions any salary continuation will be provided prior to the actual buyout.

If disability policies are to be used for the purpose of funding such buyouts, the definition used in the disability policy should be the same definition as that specified in the buy-sell agreement. In a similar manner the elimination period for the disability policy should exactly dovetail with the elimination period specified in the buy-sell agreement. Sometimes buy-sell agreements contain a reversal clause to deal with a shareholder�s potential recovery after the buyout starts but before the full purchase price has been paid.

Funding the buy-sell agreement can be accomplished by either an entity plan where the corporation buys the stock from the disabled individual or by a cross-purchase plan where each of the nondisabled co-owners purchases a portion of the ownership interest from the disabled owner. Under an entity arrangement the corporation purchases policies on each of the owners and has the benefits payable to the corporation for purposes of purchasing the stock from the disabled owner. The arrangements must be set up very carefully with the advice of tax counsel. (These transactions are subject to the attribution rules and other tax considerations that are beyond the scope of this course. More thorough treatment of these tax issues is provided in The American College course HS 331 Planning for Business Owners and Professionals.)

Under the cross-purchase arrangement each one of the business owners purchases policies insuring the other co-owners and paying benefits to the purchaser-owner of the policy. This arrangement provides benefits to each of the nondisabled owners after the insured becomes disabled, and the proceeds can be used to purchase the ownership interest from the disabled individual.

The tax treatment of a cross-purchase buy-sell occurring as a result of a disability is relatively simple. Premiums paid by the individual shareholders are nondeductible. The disability benefits they receive under these policies are tax free with respect to federal income taxes. The sale proceeds for the ownership interest of the disabled individual are capital gains to the seller by the amount that the proceeds exceed his or her basis. Since the transaction is not by reason of death, there is no basis step-up available for the ownership transfer.

For the entity-type buy-sell agreement (stock redemption) the premiums paid by the corporation for the disability policies are nondeductible. However, the disability benefits received by the corporation are tax free with respect to federal income taxes. The redemption amounts paid to the disabled owner for the ownership interest will most likely be a combination of capital gain and ordinary income. (Full consideration of these tax issues is beyond the scope of this course. Further information is available in other American College courses, such as HS 321 Income Taxation and HS 331 Planning for Business Owners and Professionals.)