Business Succession Planning Part 3: Using Disability Insurance to Protect your Business Interest
But there is a risk much more prevalent than death which also needs attention on the part of business owners and partners: the risk of Disability.
In our working lives, we are considerably more likely to become ill or injured such that we cannot work than we are to get proverbially hit by a bus and killed. So it can be argued that even more important than the need to insure our lives is the need to insure our ability to work.
There are a few ways in which business owners might consider covering off a Disability:
Buy-Sell Agreement Funding
Bob, Joe, and Dave run a successful widget business together as partners. As such, they have done their due diligence in putting together a buy-sell agreement (also known as a shareholder's agreement) in order to protect both their respective shares of the business as well as the company as a whole.
One of the clauses of the agreement surrounds disability. See, if Joe becomes disabled such that he can't do his job (which happens), then Bob and Dave have to pick up the slack. Joe might have his own personal DI policy which protects his salaried income. (However if he is paid with bonuses and dividends, he won't even qualify for a personal DI policy - that's another can of worms entirely). Either way, for a few years Bob & Dave can probably keep the company above water for the time that Joe needs to recuperate.
But if Joe's disability is long term or "permanent" in nature, the company has a whole new set of issues on its hands. Joe is no longer contributing to the success, growth, and maintenance of the company due to his disability. Should he rightfully continue to remain an owner, reaping the benefits of a business that is growing independent of his own efforts? Or is it time for Joe's share to be bought out so Bob & Dave can move on with the business, or take on another partner? (Again, Joe should have a personal DI policy, so it's not like he is being left in the dust if he's planned properly for himself).
Assuming the three of them agree, standard buy-sell agreements usually state that after a partner is disabled for "x" amount of time (usually a year), and/or if it is determined that the disability is permanent in nature, the disabled person's shares are to be purchased by the other owners or sold back to the company.
Most companies and business owners don't have the money kicking around to pay for such things, especially as the company grows and prospers over time and the amount required to buy out an owner becomes substantial. There is however a solution: to fund the agreement with a special type of Buy-Sell Disability Insurance.
The premise of Buy-Sell DI is to comply directly with the terms of the buy-sell agreement. In fact, the insurance company may require a copy of the agreement to process the application.
One of the easiest ways to implement this arrangement is to have cross-owned policies. Bob & Dave personally own a policy for Joe. Joe & Dave own for Bob, and Bob & Joe own one for Dave. It works best for partnerships of only two or three owners; more than three partners, and the cross-ownership strategy gets a little too complicated.
Once Joe has been disabled for 1 year (for example), the agreement states that his share of the business is to be bought out either in a lump sum or over a period of 2 years. The DI policy is structured to pay Bob & Dave exactly the money required to satisfy the terms of this agreement to the letter.
You can also structure this policy so the company owns it and is the beneficiary of the cash to pay out Joe, however taxation issues become a little more prevalent in this case (depending on the corporate structure).
Critical Illness insurance (you can get the basics about it here) is another way to comply with the terms of a buy-sell agreement. CI usually pays out a lump sum of money in the event of a diagnosis of a critical illness. Since most buy-sell agreements stipulate a lump sum purchase of the disabled person's share of the business, this might be a good solution. It also usually costs less than corresponding DI policies, so is great for the budget-minded business owner.
Another benefit is that qualifying for CI has nothing to do with income history; whereas buy-sell DI requires the business to have a proven financial track record before the insurance company will issue the policy. So a business in the early stages may find that CI is the only way to insure buy-sell agreements.
However Buy-Sell CI has a significant downfall in comparison to it's DI counterpart: it only pays out on the diagnosis of a specific set of illnesses and injuries. If the buy-sell agreement is broader in scope to cover off any disability for any reason (which would make sense), then there may be cases in which the buy-sell agreement kicks into effect, but the insurance policy doesn't pay out the money to grease the transaction.
In both cases, there are a number of snares and pitfalls that can be avoided with proper legal, tax, and financial planning. It is imperative that consultations with your team of financial professionals (lawyer, accountant, financial planner) should be arranged to make sure the agreements and corresponding policies are drafted to suit everybody's best interest.