Key Person Disability Insurance

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 Business entities are dependent on their personnel to carry out their activities and generate revenues and profits. Very often the unique talents and experiences of a few key individuals are crucial to the success of the business entity. The loss of an individual's contributions because of disability or death could be a devastating blow to the financial well-being of the enterprise. Sometimes the dependence is so critical that losing the individual's participation could lead to the bankruptcy or termination of the business. This is particularly true of professionals operating as sole practitioners.

Many business enterprises have recognized the importance of key individuals who make the most critical contributions and have obtained disability income insurance covering these key individuals. Benefits from key employee disability policies are payable to the business entity when the insured key employee is disabled. The justification for such coverage is very similar to that for key person life insurance policies. Proceeds from key-person disability policies can be used to replace lost revenue directly attributable to the key person's disability, to fund the search for individuals to replace the insured person, to fund the extra cost of hiring specialized individuals to replace the multiple talents of the insured and to fund training costs that may be incurred to prepare replacements to carry out the duties the insured performed. The costs of training, hiring, and compensating are usually rather easy to ascertain, whereas estimating lost revenue is a very difficult and complex task. These policies are not designed to provide continuance of salary for the key employee.

Even though a business entity may determine a desired amount of disability income protection for each key individual, it may not be able to obtain that amount of coverage. The underwriting processes of insurance companies limit the maximum amount of coverage available on any one individual. A wide range of guidelines is utilized for setting these limitations, and getting an insurer to waive any of these limitations is usually difficult. Sometimes a business entity can make a strong enough argument on both financial and economic grounds to justify an exception and obtain the desired amount even though it exceeds underwriting guideline limitations.

Premiums for a business-owned disability income policy are not deductible for federal income tax purposes if benefits are paid to the business; the receipt of these proceeds by the business is free of any federal income tax liability. Payment of those premiums does not create any taxable income for the insured employee.

Salary Continuation for Owners and Key Employees

Individual disability income policies can be purchased by the business entity to fund formal plans to continue salary for disabled owner or key employees. Formal plans can be set up in two different ways. The corporation can own the policy and be the beneficiary under the policy, or the corporation can pay the premiums on a policy owned by the employee to whom benefits will be paid. When the corporation is both the owner and the beneficiary of the policy, premium payments are nondeductible by the corporation and the corporation receives the insurance proceeds free of any federal income tax liability. Premium payments for such coverage are not considered taxable income to the employee.

When the corporation merely pays the premiums on a policy owned by the employee, the premiums are deductible expenses of the corporation as long as they meet reasonable expense criteria. The premium payments are not considered taxable income to the employee; however, benefits paid under the policy are taxable income to the employee.

In some informal plans to continue salary, the corporation pays a large enough bonus to the employee for the employee to buy an individual disability income policy. If the bonus payments are reasonable compensation, they are deductible by the corporation. The bonus is taxable income to the employee. The premium payments made by the employee are not deductible. Any benefit payments received by the employee do not affect the corporation and is received free of any federal income tax liability by the employee.

Disability Buy-Sell Funding

A business owner's disability often threatens the viability of that enterprise. Preserving the value of the business often necessitates shifting the business owner's ownership interest to one or more other individuals who can continue conducting the affairs of the business. In cases that involve multiple ownership of the business, the most likely parties to purchase the ownership interest of a disabled owner are the nondisabled co-owners. Unfortunately, few business owners have adequate amounts of liquid assets to make an outright purchase of the ownership interest from the disabled co-owner.

Just as buy-sell agreements triggered by the death of an owner can be funded with life insurance, buy-sell agreements triggered by the disability of an owner can be funded with disability insurance. Special disability policies have been designed specifically to fund buy-sell agreements. These policies can fund either an installment purchase or a lump-sum buyout.

The types of buy-sell arrangements are similar to those discussed earlier in this book for situations arising from death. However, some extra care is necessary. The definition used in the disability policy should be the same as that specified in the buy-sell agreement. The elimination period for a buy-sell policy is typically one year or longer to avoid triggering the buyout for disabilities that last less than one year. Most buy-sell policies pay the benefit in one lump sum.