Disability Buy/Sell Contracts
What happens when a Business Partner becomes
disabled?
• Would they want to sell their share of the
business?
• Would they want to buy out the healthy
partner(s)?
• How would the price be determined?
• Where would the money come from?
• Is it guaranteed to be there when it’s
needed?
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In the Event of a Disability,There
Are Many Issues to be Resolved
The disabled partner may:
• Become a drain on income while not
contributing to the business
• Have different priorities for the
business income and profits and may
not want to reinvest profits
• Decide to let their spouse or relative
take over his/her role in the business
In the Event of a Disability, there
are Many Issues to be Resolved
The healthy partner:
• May not be able to pay the disabled
partner an income and maintain the
business
• May not have funds to buy the disabled
partner out
• May not want to share business
decisions with the disabled partner’s
family
Advantages of a Buy-Sell Agreement
• Assures active business owner can buy
out the disabled owner at a predetermined
price and pre-arranged time after disability
strikes.
• Maintains business continuity and
credibility - which are concerns of
customers, creditors and employees.
4
Advantages to the Disabled
Business Owner
• Creates an automatic market by guaranteeing a
definite and fair price and a buyer for the
business interest
• Assures that his/her financial future is no longer
contingent upon the strength of the business
• Provides money which may be needed to pay
medical bills and living costs
• Avoids involving the disabled owner and his/her
family in the management of the business
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Advantages to the Active
Business Owners
• Avoids negotiation of price
• Assures complete and orderly transfer of
ownership
• Retains control of the business
• Competitors cannot purchase the disabled
owner’s business interest in the firm and
force out the active owners
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Once Again, Consider The Likelihood...
Chances of a Disability Lasting 12 Months or
Longer (before age 65)
Age
2 Owners
3 Owners
4 Owners
27
26.3%
36.7%
45.7%
37
24.5%
34.5%
43.1%
47
20.7%
29.4%
37.1%
57
12.1%
17.6%
22.8%
Commissioner’s Individual Disability Table B - Equally
Weighted 90 Day Elimination Period.
Buy-Sell Considerations
• Date to Establish a Plan
• The date the owner first becomes disabled; or
• The trigger date of the buy-sell agreement
• Method of payment
• When is the first payment due?
• How should it be paid?
• Lump sum payment
• Monthly installments
• Combination of both
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Buy-Sell Agreement Considerations
Structure of the agreement:
• Cross-purchase agreement
• Works best with two owners
• Insurance company reimburses the non-disabled owner(s)
• Receive step up in basis
• Entity purchase agreement
• Insurance company reimburses the corporate entity
• Best to use with multiple owners
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The most practical solution is...
• A written agreement that
specifies when and for
how much the buy-out
will take place, and...
• is funded with the right
amount of Disability BuySell insurance.
Why Disability Buy-Out Insurance?
• Objective
• The objective of Disability Buy-Sell
insurance is to reimburse money paid for
the purchase of a disabled owner’s interest
in the business in the event of a long-term
disability
• Benefits
• Benefits are income tax-free - the disabled
owner is taxed only on the gain from the
sale of the business*
• Provides a funding solution for the business
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How Does it Work?
• The non-disabled owner(s) are reimbursed for buyout expenses paid during the buy-sell process
• Premiums are non-deductible (IRC 265; Rev. Rul.
66-262, 1966-2 C.B. 105)
• Benefits are received income tax-free (IRC
104(a)(3); Rev. Rul. 66-262, 1966-2 C.B. 105)
• The disabled owner is taxed only on the gain from
the sale of the business. The gain may be
considered an installment sale if at least one
payment is to be received after the close of the tax
year in which the sale was made. Clients should
contact their tax advisor for details.
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Cross Purchase Agreement
• Each owner owns a policy on each of the other
owners
• After disability, the non-disabled owner(s)
purchase the disabled owner’s share in
accordance to the Buy-Sell Agreement and
receives policy benefits (up to the maximum
policy limit) as a reimbursement
• The non-disabled owner(s) then own the
business, and the disabled owner has been paid
the price agreed upon
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How a Cross Purchase Agreement Works
Business
Owner A
Buy-Sell Agreement
Premium
Policy and
Disability Benefits
on Owner B
Business
Owner B
Premium
Insurance
Company
Policy and
Disability Benefits
on Owner A
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Advantages/Disadvantages of a
Cross Purchase Agreement
Advantages
• Policies are not available to business
creditors
• Non-disabled owners receive an increase in
their basis
Disadvantages
• If there are more than two owners, the
number of policies needed may not be
practical
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Entity Purchase Agreement
• The business purchases and owns a disability
buy-out policy on each owner
• After disability, the business purchases the
interest of the disabled owner in accordance to
the buy-sell agreement and receives policy
benefits (up to the maximum policy limit) as a
reimbursement
• The non-disabled owners then own the business,
and the disabled owner has been paid the price
agreed upon
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How an Entity Purchase
Agreement Works
Business
Owner A
Buy-Sell
Agreement
Business
Owner B
Business
Premium
Buy-Sell
Agreement
Policy and
Disability Benefits
on Owners A and B
Insurance
Company
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Advantages/Disadvantages of an
Entity Purchase Agreement
Advantages
• Only one policy per business owner is
necessary
Disadvantages
• Policies are open to claims by
creditors
• The buy-out will not increase the
healthy owner’s basis
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Ideal Candidates
• White to Gray Collar, small to mediumsized businesses with less than 10
owners
• 10% ownership to be considered
• Need to have a plan for succession
• Owners that depend on each other to
keep the business running smoothly
19
Common Methods to Calculate
Business Value
• For Personal Service Businesses:
- 2 times income plus the profit of
the business
• For General Businesses:
- Book value plus capitalization of
excess earnings
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Elimination Periods
and Pay Out Methods
•
•
•
•
365, 540, or 730 Day Elimination
Lump Sum
Monthly Installments over 2, 3, or 5 Years
Combination of Lump Sum and Monthly
Installments
21
Issue and Participation Limits
•
•
•
•
Total Pay Out: Up to $2,000,000
Limits per Occ Class
Limits per Pay Out Method
Limits per Elimination Period
22
Disability Buy/Sell Underwriting
• Financial:
Most Recent Business Tax Returns, all
schedules.
(Three Full Years Preferred)
• Medical:
Telephone Interview (all amounts and ages),
Blood/Urine, Para Med, EKG (by amount, age, and state)
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Disability Buy/Sell Carriers
•
•
•
•
•
Berkshire/Guardian
MassMutual
MetLife
Principal
Standard
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