Buy-Sell Disability Insurance
Buy-Sell Disability Insurance is designed to help fund the purchase of a business owner's interest if a qualifying disability prevents them from continuing to work in the business.
For businesses with multiple owners, planning for an owner's death is only part of a comprehensive succession strategy. A prolonged disability can create an equally important question: what happens to an owner's business interest if they can no longer actively participate in the company?
What Is Buy-Sell Disability Insurance?
A buy-sell agreement establishes how an owner's interest in a business may be transferred following certain triggering events. While death is commonly addressed through life insurance, a properly structured agreement may also address what happens following a long-term disability.
Buy-Sell Disability Insurance is designed to provide funding for the purchase of a disabled owner's business interest following a qualifying disability and the satisfaction of the policy's requirements.
This can help provide the remaining owner or owners with the financial resources needed to complete the transaction while allowing the disabled owner to receive value for their ownership interest
How Does Buy-Sell Disability Insurance Work?
Buy-Sell Disability Insurance is generally coordinated with a business's buy-sell agreement.
The agreement establishes the circumstances under which an ownership transfer may occur, while the disability insurance provides a potential source of funding for the transaction.
If an insured owner experiences a qualifying disability and the applicable requirements are satisfied, policy benefits may be used to help purchase that owner's business interest.
Because both the insurance policy and legal agreement play important roles, coordination between the business owners, insurance professionals, attorneys, and other advisors can be important when establishing the arrangement.
Why Address Disability in a Buy-Sell Agreement?
Without a disability provision and a method of funding the purchase, a prolonged disability can create uncertainty for both the disabled owner and the remaining owners.
Questions may arise regarding:
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Who will manage the business?
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Will the disabled owner continue receiving compensation?
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How long will the disabled owner retain their ownership interest?
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Who has voting or management authority?
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How will the business interest be valued?
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Can the remaining owners afford to purchase the disabled owner's interest?
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What constitutes a disability severe enough to trigger a sale?
Establishing these provisions before a disability occurs can help create a clearer process for everyone involved.
Who May Consider Buy-Sell Disability Insurance?
Buy-Sell Disability Insurance may be appropriate for businesses with two or more owners where each owner's continued participation is important to the organization.
Common situations may include:
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Closely held businesses
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Professional practices
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Medical and dental practices
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Law and accounting firms
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Partnerships
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Multi-member LLCs
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Corporations with multiple active shareholders
The appropriate structure depends on the ownership arrangement, business valuation, buy-sell agreement, and financial circumstances of the owners and business.
How Is the Amount of Coverage Determined?
The amount of Buy-Sell Disability Insurance generally relates to the value of the insured owner's interest in the business.
Determining an appropriate amount may involve consideration of:
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Current business value
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The insured's ownership percentage
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Terms of the buy-sell agreement
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Method used to value the business
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Existing insurance coverage
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Financial condition of the business
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Available carrier limits
Financial documentation and information supporting the business valuation may be required during underwriting.
Because business values can change over time, the buy-sell agreement and corresponding insurance coverage should be reviewed periodically.
Coordinating the Insurance With the Buy-Sell Agreement
One of the most important considerations in Buy-Sell Disability Insurance planning is coordination between the insurance coverage and the underlying legal agreement.
For example, the definition of disability, timing of a potential ownership transfer, valuation methodology, and funding mechanism should be reviewed as part of the overall planning process.
An insurance policy does not replace a properly drafted buy-sell agreement, and a buy-sell agreement does not itself create the funds needed to complete a transaction.
Business owners should work with their legal, tax, and financial professionals when establishing or reviewing a buy-sell arrangement.
Frequently Asked Questions
Does Buy-Sell Disability Insurance replace the disabled owner's income?
No. Buy-Sell Disability Insurance is designed to help fund the purchase of the disabled owner's business interest. Individual Disability Insurance is generally used to help protect the owner's personal earned income.
When does a disability trigger a buyout?
The timing depends on the terms of the buy-sell agreement and the applicable insurance policy. A prolonged disability may need to continue for a specified period before benefits become payable or an ownership transfer occurs.
How is the business valued?
The valuation method should generally be established in the buy-sell agreement. Depending on the arrangement, valuation may involve an agreed value, formula, appraisal, or another method developed with the business's professional advisors.
Is Buy-Sell Disability Insurance the same as life insurance used to fund a buy-sell agreement?
No. Life insurance provides funding following the insured's death, while Buy-Sell Disability Insurance addresses a qualifying disability. A comprehensive buy-sell funding strategy may consider both risks.