Many companies and closely-held businesses have made arrangements to purchase outstanding interests of the business at
the death of a partner or shareholder/employee.
While a company's buy-sell agreement probably includes funding with life insurance, many businesses overlook the need to plan a properly funded disability buy-out
agreement.
While a company can face some dramatic problems in the event of an owner's death, it is also important for business owners to consider the detrimental effects of a co-owner's long-term disability.
In addition to paying a salary to a non-productive employee, disability can reduce a company's total productivity.
When productivity is affected, profits are affected. Thus, companies may find it difficult
to hire replacement employees. The disability of one of the owner's can also affect customer and creditor relationships. A solution to the difficulties caused by an owner's disability can be a funded disability buy-sell agreement.
The healthy owners or the business itself agrees to buy out the disabled owner(s) and obligates the disabled owner(s) to sell at a predetermined price. A company has a number of options available in order to fund the disability
buy-sell agreement. But, since most require heavy borrowing or the use of cash, which may come from working capital, the best method of affecting a disability buy-out may be to fund the agreement with disability buy-out insurance.
The amount the company pays to the shareholder/employee, for the period before the buy-out, can be deducted by the company as compensation in certain cases. However, the payments are no longer deductible once they are
made to the disabled shareholder as payment for his or her stock.
Payments received by the disabled person prior to the buy-out may be deductible as compensation if they are considered salary consideration payments.
When the payments are made as payments for stock, the shareholder will realize gain to the extent that the purchase price exceeds his basis.
There are two types of buy-sell agreements, the cross purchase and the entity
purchase. Under a cross purchase agreement, the owners, rather than the business, own policies, pay premiums and receive benefits when an owner is disabled.
For example, assume A and B own half of company XYZ, valued
at $1 million. The buy-out agreement states that if A becomes disabled, A would sell half of the business to B for $500,000 pursuant to their agreement. B pays A $500,000 (in installments or in a lump sum). The final result is
that the value of the $1 million business is now owned 100% by B, and A has received a cash pay out of $500,000.
Under the entity purchase agreement, the business organization - not the principals - owns the policies,
pays the premiums and receives benefits when an owner is disabled. The agreement is made between the principals and the business organization. If an owner is disabled, the business organization then purchases the disabled owner's
interest.
For example, company ABC is valued at $1,600,000 and has four owners. Each owner's interest is worth 25% ($400,000). Assume owner A becomes disabled and sells the business interest to the business for
$400,000 in either installements or in a lump sum. This will result in the business still having increased their share of ownership of the company.
Disability buy-out coverage may be the most overlooked aspect of a
funded buy-out agreement. It is important to make sure that your company establishes a plan while all owner/stockholders can meet insurance qualifications. By doing so, you can maintain business continuity and ownership interests
intact should a partner become disabled.
