J—Disability Buy Out Insurance

Disability buy-out insurance is designed to provide funds for the purchase of a disabled owner’s interest in a corporation or partnership after an extended period of permanent and total disability. The benefits of such insurance include: (1) providing funds for the purchase, which funds are not tied to the continued success of the business; and (2) assuring that the disabled owner will no longer be a drain on business income and assets. In contrast, see the discussion of business overhead expense insurance.

A business is usually not eligible for coverage until it has been in existence for two years, although exceptions can be found (e.g., professional corporations). Maximum amounts of coverage typically range from $300,000 to $1,000,000, with specific amounts limited to a percentage of the owner’s interest (e.g., 80 percent of fair market value). As with disability income insurance, definitions of disability vary widely, from inability to engage in one’s “own occupation,” to inability to perform the duties of “any other occupation” for which one is reasonably suited. It is absolutely essential that the provisions of the purchase agreement be consistent with the definitions and terms of the disability buy-out policy.

Because a disabled individual’s chances of recovery are highest in the early months of his disability, the waiting period is extended and typically lasts from 12 months to three years. This attempts to avoid the forced sale of a business interest while the disabled owner might reasonably expect to return to work. Benefits are paid to the “loss payee,” who is that individual or business entity having the contractual obligation to purchase the disabled owner’s interest (i.e., entity purchase or cross purchase. Payment of proceeds can vary from lump sum to installment, with lump sum having the advantage of simplicity, but losing the tax advantage of spreading gain over a number of years.

Successive disabilities can cause a problem when the insured returns to work after being disabled for less than the waiting period, and thereafter suffers a second period of disability. Some policies require satisfaction of a new waiting period, while others consider both disabilities to be “continuous,” provided the gap between them does not exceed a certain period. If the insured recovers after the end of the waiting period, but prior to the last indemnity payment, some policies will stop all future payments, while others disregard the recovery and make payments as originally scheduled (i.e., a form of “presumptive” disability). 

Although the premiums are not tax deductible, the benefits are received tax-free by the loss payee. As with any other lifetime sale of a business interest, the disabled owner is subject to capital gains taxation of any gain on the sale of his business interest.

An alternative to traditional disability buy-out insurance is the use of a hybrid long-term care product combined with life insurance. These are usually attached to life insurance contracts in the form of a rider that carries an additional cost. Although these riders do not address the full  range of disabilities, they can allow the acceleration of a life insurance death benefit when an insured has a long-term care triggering event. These are usually the inability to perform one of the traditional activities of daily living or a mental impairment. These riders may be a cost efficient alternative to true disability buy-out coverage. However, care needs to be exercised in the type of long term care rider that is selected. These riders may vary widely in terms of the ability to have a payment made to the business entity to tax efficiently fulfill the buy-out and receive funds, the circumstances under which a rider might be triggered. These are often driven by the underlying insurance carrier, the underlying filing and the state requirements. By its contract language, at least one major life insurance carrier requires that reimbursement for long-term care benefits be made to the insured. Such a reimbursement rider, as opposed to an indemnity type rider payable to the policy owner, creates tax, as well as fiduciary, issues if owned by a thirdparty (such as a trust, business, or co-shareholder).

Increasingly a number of life insurance carriers are offering long term care (or chronic or critical illness) riders or combination products associated with their life insurance policies. For an additional premium (often a reasonably modest amount – such as 10 percent to 15 percent) a policy owner can accelerate some or all of the death benefit covering the insured upon the triggering of a long term care event. Some combination (or Hybrid) products can be purchased for no additional premium – instead the product may only have a cost if/when the rider is activated by the policyholder.

These Hybrid products do not always cover every disabling contingency but can cover many events. These can be low cost alternatives to traditional disability policies, but can also be complex. The state filing, policy structure and ownership of these products are critical. However, in the right conditions they can be effective in a business continuation setting.