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The success of a small business depends largely on the productivity of its owners. If one of the owners in a partnership becomes disabled, the company will suffer financially.
That’s why small businesses should have a buy-sell agreement that details what happens to the shares of the disabled partner. Who will purchase their shares? How will the shares be valued?
Perhaps most importantly, where will the funding come from? A buy-sell disability policy is the crucial piece that completes the buy-sell agreement. Learn more about how it works and why you need it to protect your business.
Why You Need A Buy-Sell Agreement
When a corporation has more than one shareholder, it’s advisable to enter into a buy-sell agreement, which usually forms part of the shareholder’s agreement. A buy-sell agreement sets the rights and obligations of the shareholders and company upon the death, disability, retirement, dispute, or marital breakdown of an owner.
The goal of the buy-sell agreement is to facilitate the smooth transfer of the shares from the departing shareholder to the remaining owners. Doing so can help the company avoid forced liquidation and divisive litigation.
A buy-sell agreement addressing the total disability of an owner should define the following:
What happens to the shares of the totally disabled partner, including identifying the purchasing party
Whether the purchase/sale of the disabled owner’s shares is optional or mandatory
How the shares will be priced
The triggering event for the buy-out
How the buy-out will be funded
The final three points should align with the disability insurance policy funding the buy-sell agreement. For instance, the triggering event for the partner buy-out should be coordinated with the triggering event for the disability buy-sell policy. You wouldn’t want to trigger the buy-out if the disability buy-sell policy doesn’t pay.
Also, if you are going to use disability insurance policies to fund the buy-out, you will want to make it a requirement to purchase these, keep them in force, and reference their policy numbers in the buy-sell agreement.
Having a bulletproof buy-sell agreement in place along with the proper disability insurance policies will help avoid disputes between the remaining and disabled partners. It will also reassure employees, suppliers, customers, and creditors about the company’s financial health and its continuity.
How buy-sell agreements benefit all parties
Disabled partner
Now that the partner is disabled, he can no longer contribute to the success of the business. As a result, he may want to exit the business and realize the full market value of his shares. The buy-sell agreement allows his business partners to buy out his shares at a fair price as previously agreed upon.
Remaining owners
The buy-sell agreement aims to provide the remaining owners with the priority to buy out their disabled partner, preventing competitors from doing so first. Also, it removes the need to involve the disabled owner’s family members in the business. Finally, a properly structured agreement establishes the valuation method to ensure a fair purchase price.
What Is Disability Buy-Sell Insurance?
Disability buy-sell coverage is for business partners who want insurance to provide funds to buy out a disabled owner per the buy-sell agreement. The funds from the insurance company minimize disruptions to the business’s cash flow.
The buy-sell agreement should specifically reference the disability insurance policies. It should trigger the buy-out when the insurance pays a benefit due to an injury or illness of one of the owners.
When does it pay?
A total disability is one where an injury or illness prevents a partner from performing the essential duties of his occupation. Aside from that, he must also be under the care of a physician.
The insurance company makes the benefit payments after the disability has lasted at least 12 months. Also called the waiting period or elimination period, this prevents the buy-out from being triggered too early in a disability.
While the disabled owner may want a longer waiting period because the business may still be a source of continuing income, the remaining partners may wish to execute the buy-out sooner to move on with business. As a result, you will want to discuss among yourselves to determine the appropriate waiting period.
Other waiting periods include 18 and 24 months. One of the benefits of a more extended waiting period is saving on premiums.
Funding methods
The main options for receiving the money from disability buy-sell coverage is via a lump sum benefit, by installments, or a down payment followed by installments.
If you choose the lump sum benefit payments option, the disability insurance policy will enable a total buy-out once a partner is totally disabled.
On the other hand, the installment method occurs over a period of up to 10 years. First, the remaining shareholder buys the disabled party’s shares with a promissory note. Then, the funds received from the insurance company would be used to repay the promissory note. A benefit of this method is that the disabled shareholder can spread out the capital gain over several years.
How much can you get?
The smallest benefit amount you can get is $50,000, while the largest lump sum benefit is $2,000,000.
However, the buy-out expense limits the insurance proceeds. Therefore, if you buy a benefit amount greater than the actual buy-out cost, the insurance company will pay the lower amount and refund the premiums paid for the excess.
For example, if it costs $1,000,000 to buy out the disabled shareholder and you purchased $1,500,000 of lump-sum benefit, the insurance company will pay $1,000,000 and refund the premiums paid for the excess $500,000.
Properly valuing your business is vital to executing a buy-out. Refer to the business valuation section below for tips on how to value your company.
Optional benefits
Because the coverage amount you buy is only a snapshot of your business at that moment, you will want to get the future insurance option. This allows you to purchase additional insurance as your business grows without providing medical evidence of insurability. As a result, this rider guarantees you can increase the coverage even if your health deteriorates. However, you would still need to show financial evidence of your company’s growth.
Who needs buy-sell disability insurance?
Small businesses with two to five owners should get buy-sell insurance to protect their interest in their companies. In particular, ideal candidates are closely-held corporations that employ less than 50 people, have up to $10 million in sales, and work in the following stable industries.
Accounting firms
Advertising agencies
Architectural firms
Employment agencies
Engineering firms
High-tech and computer firms
Law practices
Medical practices and clinics
Small manufacturers
To qualify, you:
Must be between the age of 18 to 60
Work at least 30 hours per week
Must have an individual disability insurance policy
Must also get buy-sell insurance for life insurance
Cannot work in a public company
Cannot be a husband-wife or parent-child combination
Should have at least three years of experience in partnership
Must have a company worth at least $50,000
Must own between 10-90% of the company
Must have a buy-sell agreement within one year of purchasing the insurance
How Do You Structure A Buy-out?
There are two main ways to structure a buy-out: a cross-purchase agreement and a stock-redemption method. Each has its unique benefits and tax consequences.
Cross-purchase agreement
With this method, each shareholder owns a disability insurance policy on each of the other shareholder(s). Once a disability occurs, the non-disabled shareholder(s) will receive the insurance policy proceeds and use them to buy out the disabled principal. Because of the number of policies required for larger groups, this method is most feasible for smaller firms with two owners.
For companies with more than two owners, you can use a trust to hold the policies. The trust also receives the benefit, which it can use to buy the disabled partner’s shares and distribute them to the beneficiaries of the trust—the remaining owners.
If a buy-out occurs, the disabled partner will have a capital gain equal to the purchase price minus his adjusted cost base. Like any other capital gain, 50% of it is taxable. If the business is a qualified small business corporation (QSBC), he may realize a tax-free capital gain known as the lifetime capital gains exemption (LCGE). This amount is $971,190 in 2023 and is indexed to inflation.
Stock-redemption method
Instead of individually owned policies, the corporation is the owner for the stock-redemption method. It holds the policies, pays for them, and names itself the beneficiary of the proceeds of the insurance. Once it receives the benefit, it uses it to redeem the shares of the disabled principal.
This buy-out qualifies as a taxable deemed dividend. Because it’s not a capital gain, the disabled shareholder wouldn’t be able to claim the LCGE.
How Do You Value Your Company?
Business valuation is not a simple task and can be described as more of an art than a science. Factors like the reputation of the business, its location, continuity of staff and customer loyalty may all increase its value.
You should fund the disability buy-sell agreement with an amount that reflects the value of the company. One of the ways to do so is with a professional business valuation done by a member of the Canadian Institute of Chartered Business Valuators.
Insurance companies also provide a simplified method of determining your business value. Depending on your industry, you can use a formula to calculate it.
Industry | Formula |
|---|---|
Medical professionals | Net book value + average gross billings * 0.75 |
Legal and accounting firms, insurance agencies | Net book value + average gross billings * 1.2 |
All other businesses | Net book value + average net income * factor |
The net income multiplier for all other businesses ranges from one to seven depending on the industry. For example, small personal service businesses dependent on the owners’ expertise would have a factor of two, while stable manufacturing businesses would have a factor of seven.
Frequently Asked Questions
What is the buy-sell agreement?
A buy-sell agreement sets the rights and obligations of the owners and company upon the death, disability, retirement, dispute, or marital breakdown of a shareholder.
Who owns a buy-sell disability policy?
Depending on how it’s structured, you can either own the disability buy-sell policies individually, via a trust or with your corporation. Each method has its advantages and tax consequences.
How is buy-sell disability insurance taxed?
Regardless of the type of policy ownership—personal or corporate—the premiums paid for disability buy-sell coverage are not tax-deductible. However, the insurance payout is tax-free.
When a disabled partner gets bought out, he will have to pay income tax. The cross-purchase agreement method results in a capital gain for the disabled owner, which could enable him to claim the LCGE.
On the other hand, the stock-redemption method results in a taxable deemed dividend to the disabled owner.
What other types of business insurance should you get?
Besides disability buy-sell insurance, you should also consider the following insurance policies to protect your business.
Buy-sell life insurance
This type of buy-sell insurance funds the buy-out of the shares of a deceased shareholder. Buy-sell life insurance gives the surviving partners the cash to buy the shares from the deceased shareholder’s estate.
Key person disability insurance
Key person disability insurance provides a financial cushion to help handle the disability of a key employee. Upon the total disability of the key employee, the insurance company pays a benefit to the company to offset lost sales, cover the cost of hiring a replacement, and keep operations afloat until the key employee returns.
Wage loss replacement plan
A wage loss replacement plan provides superior income replacement coverage for employees than group LTD.
Business overhead expense insurance
Business overhead expense insurance reimburses the company for its fixed expenses during the disability of an owner. While these expenses like rent, utilities, and employee salaries will continue, your company’s revenue may not due to your disability. Therefore, this type of insurance pays for these business expenses until you fully recover.
Need To Execute A Disability Buy-sell Plan?
When considering disability insurance to fund, the first step is to have a meeting between the owners to determine their goals if one of them became totally disabled. Upon agreeing on a buy-out, the next step is to draft the buy-sell agreement and set up the disability buy-sell policies.
Along the way, you will need the advice of professionals like lawyers, accountants, or business valuators. Of course, you’ll also need an insurance advisor to design the disability insurance policies.
We work with businesses to ensure they have the right coverage to fund their buy-sell agreements. Contact us at info@briansoinsurance.com or 604-928-1628 to discover how we can help you structure your disability buy-sell policies.
Get Your Buy-Sell Disability Insurance Quote Now
While we make every effort to keep our site updated, please be aware that timely information on this page, such as quote estimates, or pertinent details about companies, may only be accurate as of its last edit day. Brian So Insurance and its representatives do not give legal or tax advice. Please consult your own legal or tax adviser. This post is a brief summary for indicative purposes only. It does not include all terms, conditions, limitations, exclusions, and other provisions of the policies described, some of which may be material to the policy selection. Please refer to the actual policy documents for complete details which can be provided upon request. In case of any discrepancy, the language in the actual policy documents will prevail. A.M. Best financial strength ratings displayed are not a warranty of a company’s financial strength and ability to meet its obligations to policyholders.
