379 / What are the tax consequences when disability insurance is purchased on the lives of business owners to fund a disability buy-out?

Where a buy-out occurs between a corporation and a disabled shareholder, if the transaction qualifies as a complete redemption of all the shareholder’s shares, the redemption will be treated as a capital transaction ( Q 300). That is, the transaction will be considered the sale of a capital asset and the selling shareholder’s gain or loss will be measured and taxed. A disability buy-out between shareholders also is a capital transaction and is taxed accordingly.²

Where a buy-out occurs between a partnership and a disabled partner, resulting in a termination of the disabled partner’s interest, the transaction is taxed under the rules applying to a liquidation of a partner’s interest ( Q 311).

Where a buy-out occurs between partners, the transaction is taxed under the rules applying to a sale of a partner’s interest ( Q 311).

When a disabled business owner realizes gain on the sale of his or her business interest, the amount of gain is includable in his or her gross income in the taxable year in which the gain is actually or constructively received unless the gain is includable in a different year due to the taxpayer’s method of accounting.³ If a sale qualifies as an installment sale, a pro rata portion of the gain is reportable for each taxable year installment payments are received.