Disability can pose business continuation risk

A recent survey of business owners by the Life Insurance Marketing Research Association reveals that 75 percent of business owners have not done a good job of planning for continuation of their business.

Of those wiser businesses that do plan for succession, many purchase life insurance to help ensure that sufficient funding is available in the event of a business principal’s death.

But what if a living partner or owner becomes disabled and can no longer help run the business? Will the business’s assets need to be liquidated for the funds needed to buy out the disabled partner or owner? How will that impact the business itself?

A comprehensive buy-sell agreement can protect against permanent disability by incorporating a disability-income insurance policy structured to facilitate a buy-out of the disabled partner. Typically, this is included or added to a buy-sell agreement that covers a partner or shareholder’s death, but a separate agreement may also work.

Disability income insurance designed for buy-out purposes provides the funding necessary to purchase a disabled person’s share of ownership in a corporation—or that person’s interest in a partnership—eliminating the need to fund the buy-out from the business itself.

A business is not normally eligible for disability insurance to fund a buy-out until it has been in business for at least two years. Exceptions are sometimes made if the owners of a new business have experience in managing the same type of operation.

A buy-sell agreement might be structured as either a “cross-purchase plan” or a “company buy-back plan.” In a cross-purchase plan with two or more partners, each partner will agree to purchase ownership rights of the deceased or permanently disabled partner. A corporate cross-purchase plan works much the same way if the number of stockholders is manageable.

In a buy-back plan, the corporation agrees to buy back the ownership. With either type of plan, life insurance and/or disability income insurance is the least expensive way to fund the plan.

Premiums for a cross-purchase plan are typically paid by the protected partner. In a company buy-back arrangement, premiums are paid from the proceeds of the business. In the event of a disabling illness or injury, the benefits are paid to the entity that has been paying the premiums, which generally helps ensure that, as with life insurance, the benefits are received tax-free.

The benefits from a disability policy can be received in a lump sum, and opting for this payout choice often makes the transfer of funds quicker and simpler. Note, however, that it is possible some tax advantages may be sacrificed by not spreading insurance proceeds out over multiple years.

All parties involved should determine if the security that can come from resolving business succession issues in a relatively short period of time offsets any tax advantages achieved by spreading payment over a period of years.

Note, too, that in most cases premiums paid for the disability income insurance are not a deductible expense to either the individual or the business.

If the partners or corporate owners of a business already have a buy-sell agreement in place, and they want to protect themselves from the threats to their business that permanent disability carries with it, they may only need to amend their current agreement. Whether disability issues are covered by a separate agreement or by a combined death and disability arrangement, it is recommended that the agreement be reviewed periodically by an attorney and tax consultant and updated as necessary.

Even for those who already have a buy-sell agreement in place, it’s wise to periodically comparison shop the product used to provide the funding. Many providers have improved their rates in the recent past and implemented new features, which may better fit a business’ succession plan.

For more information, consult your financial planner, attorney, tax consultant or life insurance agent. AAA Michigan and its agents do not provide legal or tax advice.

This article was written by Ray Gronevelt, a AAA Michigan financial planner who serves the Upper Peninsula from his office in the Houghton-Hancock area, and Mike McDonald, a AAA Michigan financial planner located in Dearborn.