A specialized but very important area of Disability Income insurance used for business purposes, is that of business overhead expense insurance. As the term indicates, this provides for the needs of the business if the owner (or principal) becomes disabled and is therefore not able to perform their important role in the business or to generate most of the sales.
This type of coverage is of importance to self-employed professionals, and to business owners and entrepreneurs as they must continue to meet payroll each month, pay the rent, utilities, taxes, insurance premiums, etc., etc. even if they become disabled and are no longer able to actually contribute to the business.
If such should happen, they may try to stretch out their payment of these obligations, even though it would eventually hurt their credit. Of course, one of the first things that would come to mind is the expenditure of personal savings and other personal assets to keep the business afloat. This could very easily put their family’s well being in jeopardy and possibly even lose their home. A personal Disability Income policy usually covers only the personal costs of the disabled person, so any expenditure of those funds would again cause a cash crunch on the family.
The business owner could try to hire a replacement – usually very difficult to do, but even if successful, it would take considerable funds. Therefore, they would likely start liquidating inventory at prices designed to move the product quickly, which is a good situation for consumers, but almost always a death knell for the company. Employees will have to be let go and eventually the business owner will have to close the business.
Business overhead insurance is not attractive to large corporations as they usually have several sources of income and the loss of one Key Employee is not that crippling to the corporation. But to a doctor or dentist or sole proprietor of a small business where the owner brings in most, if not all, of the firm’s revenue, what will happen if they become disabled?
These policies used to be issued to professional persons primarily, and were called “professional overhead policies.” However, they now are issued to manufacturers, wholesalers and retailers, and the name “business overhead” now encompasses all policies of this type.
The policy concept is rather simple. When the business owner becomes disabled, the policy pays a monthly benefit. The benefit is based upon the overhead of the business, and not on the insured’s personal earnings (gross) or anticipated profits. However, the business owner can also insure (up to) 100% of the company’s tax-deductible expenses (as opposed to the limits of 60%-70% of an individual’s gross earnings).
The “eligible” expenses are those that are necessary for the operation of the business, and can be considered “usual and customary.” Most insurance companies will reduce or eliminate any business expense from coverage, if such expense could be reduced or terminated by the disability. Expenses typically covered under these policies include (but are not limited to):
Expenses that are usually not covered, include
With the application for overhead insurance, the insurer will provide a questionnaire for the insured to complete, listing information on business ownership, number of full-time and part-time employees, and the insured’s share of normal monthly business expenses and other expenses not paid monthly.
The policy form is rather simple and not at all complicated. There are only a few basic policy provisions that need to be discussed.
Usually the definition is the one that simply states that benefits are payable if the insured is unable to perform his duties in the business, which is basically the own-occupation type of definition.
Elimination periods are typical 30, 60 or 90 days, with benefit periods of 12 to 24 months under the theory that if the insured is disabled for more than two years, it is more than likely that the business is no longer existing or is awaiting sale.
The amount of the benefit depends entirely on the expenses that the firm anticipates and the income flow from the business. One should keep in mind that the more the revenue from the business is likely to decline due to disability of the owner/principal, the larger the benefit amount that is needed.
This policy has a provision that states that the maximum monthly overhead expense benefit is the maximum amount of benefit that will be paid to the insured during a given month of disability. If the actual expenses of overhead are less than the policy maximum, the insurer will pay only the actual expenses up to the maximum amount (making this an indemnity policy – the insurer pays for the actual loss to the insured, but does not allow the insured to profit from a loss). Therefore, the monthly benefit would depend on the overhead business expenses for that particular month.
This situation can be best explained by using an illustration. Assume that the policy is a 12-month policy with benefits of $1,000 per month (for simplicity). Further assume that when the insured is disabled, the overhead expenses actually only totals $800 per month. The question is obviously, what happens to the other $200 per month.
An insurance company could just pay the $800 per month, and at the end of the year, $2,400 of benefits would be lost.
The most logical approach and that offered by some insurers, is that in the above situation the policy may allow for a carryover whereby the benefit period is extended in order to “use up” the unused maximum monthly benefit that has accumulated. In the above example, this would extend the benefits for an additional 3 months of coverage.
Another situation could be where the actual expenses are $800 one month, $1,000 the next month, and $1,200 the next month. With some policies, the benefits for the month when expenses exceeded the policy benefits would not be paid. In other policies, there is an accumulation provision that, using the example above, the additional $200 of benefits not paid the first month, could be used to pay the $200 excess in the third month. In other words, the months in which the total benefit is not used, it can accumulate and be used when the expenses exceed the policy benefits. If there were still unused benefit “credits” at the end of the policy period, the policy would automatically be extended until all the benefits are used.
Partial disability in these policies varies from the typical definition of partial disability in individual policies because the insured is usually able to earn some income during the disability period – especially if the insured owns the business. Partial disability is defined as a disability that follows a period of continuous total disability for which benefits are payable.
Typically, the insured may receive 50% of the benefits that would be payable if the insured were totally disabled. It is usually paid for a period not to exceed 6 months if the insured is working at his regular occupation and can perform a portion (but not all) of these duties. They may also provide that benefits are paid if the insured can perform all of his duties for his “regular” occupation, but not for more than half of the time every day that was previously required to perform the functions.
Some overhead expense policies will pay for the salary of a temporary replacement that specifically is hired to perform the duties of the disabled person, after disability is incurred. This is generally limited to others than members of the insured’s family, and the amount cannot exceed the maximum monthly benefit and overhead expense maximum.
Most overhead expense policies pay a death benefit if the insured dies during the time that he has been disabled and is eligible for benefits under the policy. There can be provisions that the insured must have been disabled for a period of at least 3 months and death must have occurred while the insured was on disability and prior to age 65.
The benefit is usually a portion, such as two or three months, of the maximum monthly benefit for total disability.
If the business owner sells the business, he will have the right to convert to an individual disability insurance policy if the insured is not disabled. The new policy would have the same limits as the converted policy, but the elimination period can be longer, monthly income benefits cannot exceed the monthly income benefits and the benefit period may not be longer than the benefit period of the converted policy.
In most of these policies, the insured has the option of increasing benefits (to keep up with inflation) in the maximum monthly benefit and in the overhead expense maximum.
Technically, premiums are paid by the business and the premiums are allowed as a business expense, therefore any benefits will be taxed. However, since business overhead expenses are tax deductible, practically speaking, there are very little, if any, taxes due.
Business continuation insurance is primarily of interest to closely held companies as business continuation in case of disability (or death) of a principal and/or owner is of primary interest. These problems arise because the owners of the business generally manage the company and work on a salary basis. Most closely held corporations are owned by a few persons, usually less than 10, and because of this, their ownership interest is not traded on an exchange so there is no ready market for their interest. Since others outside of the business are usually not interested in purchasing and running the business, those who would be interested are other owners. Frequently competitors are also very interested in these businesses.
Not only is the survival of the business in case of disability (or death) of a principal of interest to other owners, it also is of critical interest to family members.
A sole proprietorship is an unincorporated business owned by one person who usually manages and runs the business on a daily basis. Most small businesses are sole proprietorships as it is the easiest and the least complicated form of business. There are no articles of incorporation, issuance of stock, no public notice requirements, no corporation fees, etc., The most attractive feature to most small business owners is the freedom of action enjoyed by the owners. They can increase or decrease the capital of the company; they can expand operations or decrease operations, and take any (legal) action regarding the business without having to receive the approval of others.
There are disadvantages, though. Their capital structure is usually too low to allow for expansion or to enter into a business venture with another larger organization. The actual greatest disadvantage is that the sole proprietorship and the business are legally one and the same organization. The owner shares in both the assets of the business and in the liabilities of the business, and the business terminates upon the death of the owner. Of course, they can make arrangements so that the business will be transferred to another and can continue under another’s ownership.
Therefore, there are no legal distinctions between the company’s assets and the owner’s personal assets. A properly funded agreement in advance wherein the sole proprietor agrees to sell and another person(s) agrees to purchase the business or interest in the business on the disability of the proprietor, would help to preserve the business as a going concern.
The prospective purchasers could be Key Employees or friendly competitor, and a Buy-Sell agreement between the parties could be funded by Disability Income insurance in case of disability. In this situation, particularly if the purchasing entity is a friendly competitor, the premiums would be paid by the competitor.
Another method would be where Key Employees purchase the insurance. This would usually not occur as much in Disability Income insurance as in life insurance.
F If a bonus is given to the employee by the employer for the purpose of paying Key Employee policy premiums, the bonus should exceed the amount of the premiums.
The Key Employee may not be able to afford the premiums, so the sole proprietor may help the employee by giving the employee a cash bonus. If such is the case, the amount of the bonus should not be in the same amount as the premium as an employer has been held liable for the income tax on a deduction for the exact amount of Disability Income premiums. This was considered as a benefit to the employer for which the employer therefore was attempting to declare as a tax exemption. To avoid this, the bonus (or increased compensation) should be in an amount greater than the policy premium and such bonus should be used to recognize the increased efforts of the employee to become the future owner of the business.
An insured sole proprietor cannot be the owner of the Disability Income Buy-Sell policy. Even though the sole proprietor is insured, the Key Employee should be the owner of the policy and the premium payer of the policy. The premiums for a disability Buy-Sell plan is not tax deductible to the sole proprietor as a business expense but benefits are not subject to federal income tax.
A partnership is a voluntary business arrangement between two or more individuals, doing business for the purpose of profit for the co-owners. A general partnership is where all partners are active in the business and are fully liable for obligations of the partnership. A limited partnership is where there is (at least) one general partner and one or more limited partners who are not actively engaged in management of the business and who are legally liable for partnership obligations only to the extent of their investment in the partnership.
Any change in a partnership creates a new business firm. A new partner cannot be brought into the business without approval of the other partners, each and every one of them. A partner cannot sell their partnership interest or any portion of the partnership interest, without the express approval of the other partners. And importantly, the death of a partner automatically dissolves the partnership unless some provisions, written and signed by all partners, provide otherwise.
There are major problems that arise if one of the partners dies, but a different problem arises when a general partner is disabled. The attributes that the general partner brought to the business – experience, knowledge, finances, or whatever – are no longer available to the partnership. The general partner will typically remain on the payroll, but would then be a drain on the financial resources of the firm, plus the other partners must assume the responsibilities and duties of the disabled partner but at less income. They are “between a rock and a hard place” as if they replace the disabled partner, they will have to pay the salary to the replacement while still paying to the disabled partner. If, on the other hand, they do not hire a replacement, the burden on the other partners may not be bearable, particularly if the disabled partner is on disability for a long period of time.
In order to avoid this situation, it is typical for the members of the partnership to enter into a Buy-Sell agreement which obligates the surviving partners to purchase the business in case of disability (or death) of the first partner to become disabled, at a stipulated price. It also states the obligation of the other partners to purchase the interest of the disabled partner. The value of the business may be determined by a mutually-acceptable method, such as a pre-determined amount, or by formula.
Buy-Sell agreements are either an “Entity” agreement or a “Cross-purchase.”
In the Entity agreement, the business buys out the ownership interest of the disabled partner, with the agreement of every partner to sell their share if they are the first to become disabled.
The primary advantage of the Entity agreement is that it keeps down the number of policies. As an example, if there were four partners, then there would be four policies. Under the Cross-purchase plan (described below) there would have to be 12 policies.
There is also methodology to equalize the premiums among the partners or stockholders as the premiums on all policies owned by the business are added together and then pro-rated among the partners or stockholders (unless otherwise agreed to in advance). This would provide an advantage to the partners or stockholders who earn less than the others. In addition, if the business reorganizes – particular on a partnership basis – the problem of transferring policies is made much easier.
Some may consider the fact that under an Entity agreement, the worth of the business increases by the amount of the disability benefits. This has rarely caused problems, however, as a specific dollar amount is provided for each insured’s share of the business.
CONSUMER APPLICATION
John’s Auto Parts is a small auto parts store owned by partners John, Sam and Bill, each having a 1/3rd share of the business. The Buy-Sell agreement that they signed stated that in case of death or disability of any partner, their 1/3rd share would be split between the two surviving partners.
At the time of the agreement, the business was worth $1,200,000. They funded the agreement with life insurance and with Disability Income insurance policies which would pay $400,000 total - $200,000 to each partner – in case of disability.
John suffers a stroke and is totally disabled. The funds from the Disability Income policy provided a total of $400,000 to the business, thereby increasing the worth of the business to $1,600,000. Therefore, John’s financial interest is now $533,333, so the $400,000 provided by the policy is inadequate to buy out John’s share. Sam and Bill will each have to come up with an additional $66,667.
The attorney that drew up the agreement should have stipulated the worth of the business by both percentage and with a dollar amount cap.
There is one possible problem that may arise in a corporation Stock-redemption plan because in certain states, the corporation may not purchase its own shares if it does not have sufficient surplus. This could avoid forced bankruptcy if surplus funds needed to operate the business must be used to purchase the disabled person’s stock. One method that normally avoids this problem is to have a provision in the stock purchase agreement to the effect that those remaining (not disabled) stockholders will cause the corporation to do whatever is possible to overcome such a surplus drain. Note that these laws usually only pertain to “earned” surplus, therefore, as one possible solution, the stockholders might recapitalize, thereby reducing the par value of the stock of the corporation. If these laws could create a big problem, it might be better to use a Cross-purchase arrangement.
The Cross-purchase agreement is an arrangement between the business owners themselves, and not between the business and business owners.
The Cross-purchase plan is readily understood, making it easier for a partner or stockholder to understand that they each own policies on the other partners/stockholders as a method of providing funds to purchase the interest of that partner/stockholder if the partner/stockholder becomes totally disabled.
Each business owner buys Disability Income insurance only for the amount of the obligation under the Buy-Sell agreement, which in the eyes of many, is much more equitable. In addition, if a partner, for instance, owns other assets that could be used as part of the purchase price, then that individual could reduce their required fund by the value of the assets.
The big disadvantage, of course, is the number of policies that must be issued if there are several owners. Even the addition of other partners can make a plan too unwieldy to administer properly. Another administrative nightmare problem could occur if a partnership is reorganized at a later date as all of the policy ownership and beneficiary designations must be changed.
CONSUMER APPLICATION
John and Robert are equal partners in a software development company. Their business is valued at $1,000,000 now, and after reaching this goal, they purchase Disability Income insurance for Buy-Sell purposes under a Cross-purchase agreement. John purchases a policy on Robert and John pays the premiums on the policy and owns the policy. Robert purchases a policy on John and Robert owns the policy and pays the premiums. Benefits are to start two years after the disability of either party.
Three years later, Robert is totally disabled due to a series or small strokes. 24 months later, John purchases Robert’s interest in the business for $500,000, Robert sells his share in the business according to a Buy-Sell agreement drawn up before purchase of the policies. John now owns all of the business, which is still valued at $1 million.
CONSUMER APPLICATION
Aaron, Bruce and Charles are equal partners in a small business and wish to set up a disability Buy-Sell Cross-purchase agreement and fund it with Disability Income insurance. The value of the business is $1,500,000, so each partner’s share is $500,000. Bruce becomes disabled and his share is purchased equally by Aaron and Charles ($250,000 each). Each partner now owns one-half of the business, or equity of $750,000 each.
CONSUMER APPLICATION
Four golfing buddies decide to start a corporation for the purpose of wholesaling a new line of golf equipment and determine that each will contribute $200,000. Another golfer hears about this, and having had experience in this field, offers to buy in at the same price. The business is then valued at $1 million, with 5 shareholders. In the business forecast, they find that they may have to bring in other stockholders at a later date and the ownership of the company could go as high as eight.
Upon advice of their accountant and their insurance agent, they set up a Buy-Sell Entity agreement. The corporation purchases a Disability Income insurance policy on each of the stockholders, pays the premium and is the owner.
If any of the stockholders become disabled, the disabled person’s share would be paid to the corporation and the disabled stockholder is required to sell their share for the agreed-upon price.
Disability Income insurance to fund business continuation agreements, either Cross-purchase or Entity plans, is a popular use of business Disability Income insurance. These policies provide funds to a business, professional partnership or Small Corporation, to purchase the interests of a disabled partner or shareholder, and usually with a waiting period of 12, 24 or 36 months of disability. This waiting period is usually identical to the time in the Buy-Sell agreement when a disabled partner must be bought out.
Insureds are usually considered as disabled when, because of sickness or injury, they are unable to perform the major duties of their regular occupations and are not actively at work with or on behalf of the business or partnership. Benefits may be paid in monthly benefits payments, to a trustee who is obligated to pay the amount at the time of buy-out as stated in the Buy-Sell agreement. More frequently, benefits are paid as a lump sum payment or under another arrangement where payments are paid as periodic settlements, and in an amount that reimburses the buyers for the actual amount they paid to purchase the disabled insured’s interest in the business.
The maximum benefit of buyout policies are established at the time they are underwritten, and are based upon the value of the business as established by an accepted accounting procedure. Usually, the maximum insurable percentage of the worth of the individual to the business, is about 80% for a lump sum benefit. After age 60, this amount usually decreases rather rapidly as it is assumed that the business has in place retirement funds for the insured. As an underwriting measure, Disability Income insurance policies that make monthly payments for three or five years instead of a lump sum payment, also reduces the benefit considerably for ages near retirement.
There are two types of these policies:
Under this optional provision, the owner (insured) has an option of increasing the maximum expense buyout benefit without evidence of insurability on specified option dates.
Because of the volume of information that one must obtain to properly set up a Buy-Sell Disability Income insurance arrangement, small details can “slip through the cracks” that can cause problems later. In order to avoid these problems, there are certain actions that must be addressed.
The legal form used for the commercial partnership Cross-purchase agreement is not as detailed as the corporate Stock-redemption plan, for instance, but still consists of several pages, is very detailed, and is written in legal format. A well-qualified attorney must prepare the agreement. The following comments on the form itself are used just for illustration purposes.
The first part of the form lists the parties by name and by interest percentage of the business. It states the purpose of the agreement and the consideration of the contract. Note that these agreements usually cover the death of a partner as well as the disability, making it a “dual-purpose” form. To make it applicable for disability purposes, additional words (disabled partner, death or disability, etc.) can be inserted.
Following this “preamble,” the agreement usually sets forth the situations when a partner can voluntarily dispose of their interest during their lifetime. This provision is necessary as restricting the lifetime transfer of the partnership interests if the value that is established in the Buy-Sell agreement is to be valid and accepted by the IRS as true market value for federal estate tax purposes.
There is a provision that “forces” the decedent’s estate to sell and the survivors to buy, the deceased’s interest. While there are some “option” types of agreements, the binding agreement is best for practical purposes and for federal estate tax purposes.
The actual valuation of the property in case of death or disability, can create problems if not well documented before. A popular method is to set a fixed price dollar amount, with annual review and restating of the value. Some agreements provide for arbitration if the partners do not follow the valuation and revaluation provisions. Using the last valuation can lead to disagreements and possible inequities if there has been no review and restating of value over a long period of time.
The question of “good will” of the business can arise, as that is one of the most important assets in certain businesses. By using the valuation and reevaluation method, this asset can carry the weight in evaluation that it properly should. If this is used, the good will would not be taxed as income to the survivors, and it would not be deductible by the partnership as a business expense.
This fixed-price method of revaluation is attractive to many because it would probably be the most “fair and equitable” method of determining value due to the discussions and procedures for revaluation periodically. It can be adjusted which gives it the advantage of flexibility, it is simple in concept and easy to understand, and as far as Disability Income insurance is concerned, it is possible to keep the Buy-Sell agreement more adequately funded.
There are alternate methods of determining the value of the business, but the other typical alternative to the fixed-price method is that of using a “formula.” If a formula is used, the specific price to be paid for the business is not stated as the amount will be agreed upon the death or disability of the partner, but the formula will be followed. Usually this formula is the actual book value at the time or death, or some type of capitalization of earnings. Sometime the average book value of the business over a specific time period is used. While there are advantages and disadvantages to any of the approaches, the important thing is that the method appeals to all the partners and is understood by all.
There usually is a provision that states that each partner owns the insurance policy on the other partner, and the payment of the premiums by the partnership is only a matter of convenience and the partnership is not a party to the agreement.
The right to purchase additional insurance is always included as the value of the business may increase.
Even with the methods of revaluing the business, the agreement includes, if the amount collected by the surviving partners is less than the full amount of the price the survivors must pay, the method of filling this gap in detail. Usually, the method is to provide that the surviving partners execute and deliver to the insured (or legal representative) a series of promissory notes. It should be noted that the insurance does not have to equal the exact purchase price (although that is a goal) as the insurance can provide a good down payment if the survivors want to use other funds to purchase the share of the deceased or disabled partner.
Principally pertaining to life insurance (but could be applicable to Disability Income insurance also) the agreement could contain a provision that sets forth the procedure whereby a surviving partner may purchase the insurance policy on his own life in the event of the other partner’s death.
The provisions restricting the lifetime transfer of property, the provision whereby the decedent’s estate must sell and the survivors must buy the interest, and the valuation provision are essentially the same as in the Cross-purchase agreement discussed above.
The major difference between the Entity agreement form and the Cross-purchase agreement form, is the provision that states that the partnership is named the owner and beneficiary of each of the insurance policies. As mentioned earlier, the premiums paid by the partnership are not deductible for income tax purposes for the partnership.
The remainder of the agreement is the same as that for a Cross-purchase plan as described above.
STUDY QUESTIONS
1. The type of Disability Income insurance that provides for the needs of the business if he owner should become disabled, is
A. a Buy-Sell agreement.
B. a salary continuance plan.
C. a Short-term occupational disability insurance plan.
D. a business overhead plan.
2. One of the differences between a business overhead Disability Income insurance plan and a salary continuance plan, is
A. the business overhead is short term (less than 9 months), and salary continuance is long term.
B. the salary continuance is long term, and the business overhead is short term (less than 9 months)
C. the business owner can insure up to 100% of the company’s tax-deductible business expenses, as opposed to a percentage of gross earnings.
D. the business overhead plan is the only Disability Income insurance plan owned by the business.
3. Which of the following would be covered as an insurable expense under a business overhead policy?
A. Income taxes.
B. Salaries of employees.
C. Mortgage payment on private home.
D. College costs for dependent son.
4. What provision in a business overhead policy would address the problem of inconsistent benefits, such as higher than the monthly benefit one month, and lower the next, etc.
A. the maximum benefit provision.
B. the accumulation provision.
C. the retrograded premium distribution provision.
D. the charge-back provision.
5. If a business owner has a business overhead Disability Income insurance policy and sells his business. What can he do with the policy, if anything.
A. If he is not disabled, he can convert to an individual policy with the same benefit amounts, elimination period and benefit period.
B. There is nothing he can do, the policy would just lapse.
C. He can purchase a new policy with higher benefits, even if he is disabled.
D. He can transfer the policy to the new owner with no questions asked.
6. Business continuation insurance is of primary interest to
A. very large corporations.
B. those companies who have in excess of 50 stockholders.
C. union groups.
D. closely held companies where the disability of the owner is of primary interest.
7. If the employer, (a sole owner for instance) is going to give the employee a “bonus” to help him pay the premiums on a Disability Income insurance, for taxation purposes
A. the bonus must be for the same exact amount as the premium.
B. the bonus must be for an amount larger than the premium.
C. the bonus must be spread over a 3 month period.
D. the bonus should be paid “under the table” and no taxes declared.
8. The owner of a Disability Income insurance Buy-Sell policy cannot be
A. the partnership.
B. the Key Employee.
C. an insured sole proprietor (the Key Employee would be owner and premium payor.
D. a corporation.
9. An agreement whereby the business buys out the ownership interest of the disabled partner, with the agreement of every other partner to sell their share if they are the first to be disabled, is
A. a Cross-purchase agreement.
B. a salary continuation plan.
C. an overhead insurance plan.
D. an Entity agreement.
10. A Buy-Sell arrangement between the business owners themselves, and not between the business and business owners is
A. a Cross-purchase agreement.
B. a salary continuation plan.
C. an overhead insurance plan.
D. an Entity agreement.
ANSWERS TO STUDY QUESTIONS
1D 2C 3B 4B 5A 6D 7B 8C 9D 10A