The Disability Income insurance policy for Buy-Sell agreements is known by various names by various companies. One could venture that the most descriptive policy name is that of The Paul Revere Life Insurance Company’s “Business Protector.” Since the various states’ insurance department regulate policy format and wording, the wording is rather standard among companies. This description in this text is not intended to represent any particular company’s policy, but only illustrates what typically is included in such a policy.
The Cover Page and Schedule Page are much the same as in other policies, with one major exception. Some companies require a statement to the effect that a Buy-Sell agreement must be in effect within (usually one year) from the Issue Date. As a matter of fact, if there is no Buy-Sell agreement in effect within the stipulated period, the policy would be cancelled ab initio, and all premiums will be refunded. Commissions in such an eventuality are determined by company practice, but generally it is charged back.
(As with other policies, a Table of Contents follows, and a copy of the application may be attached here or at the end of the policy with a statement to that effect on this page.)
The purpose of the policy will be stated on the Cover Page and would state, in essence, that the insurer would pay benefits as provided in the policy, to reimburse the policy owner, the funds actually paid to buy the disabled insured’s “entire ownership interest in the business entity.”
Renewals are restricted to the earlier of certain dates, such as
1. The Insured's 64th birthday
2. The date the Insured terminates Active Full-Time Employment with the business entity for any reason other than Total Disability;
3. The date the Buy-Sell Agreement is ended;
4. The date the Aggregate Benefit Limit is paid; or
5. The date one person owns more than 90% of the business entity. [If one person owns more than 90% of the company, the purpose of the Buy-Sell agreement is suspect.]
Also, as mentioned above, the Buy-Sell agreement must be in effect.
The 10-day free look provision is outlined here. Illustrative wording could be:
“If You are not satisfied with the Policy, You may cancel it. Return the Policy to Us or Our agent by midnight of the tenth day after the date You receive it. If You return the Policy by mail, it must be properly addressed, postage prepaid, and postmarked no later than midnight of that l0th day after you receive it. Our mailing address is XXXXXXXXXXXXXXXXX. Within ten days after We receive the Policy, We will refund any premium You have paid. The Policy will be considered to have never been issued.”
The Benefits of the policy are shown in chart form, such as:
TABLE OF BENEFITS
BENEFIT FOR TOTAL DOWN PAYMENT MONTHLY AGGREGATE
DISABILITY STARTING BENEFIT BENEFIT LIMIT BENEFIT LIMIT
Prior to Insured’s 60th Birthday $100,000 $1,000 $160,000
On or after insured’s 60th
Birthday but prior to the
Insured’s 61st Birthday $80,000 $800 $128,000
On or after insured’s 61st
Birthday but prior to the
Insured’s 62d Birthday $60,000 $600 $96,000
On or after insured’s 62d
Birthday but prior to the
Insured’s 63rd Birthday $40,000 $400 $64,000
On or after insured’s 63rd
Birthday $20,000 $200 $32,000
As typical with most insurance policies, the first section is “Definitions.” These policies are almost always written in the third person (You, We, Us, etc.) Some of the typical definitions are as follows:
CONSUMER APPLICATION
Marie is a Senior Vice President of Marketing and one of 3 stockholders for a computer programming company, and her duties require that she travel extensively by air. Unfortunately, Marie is a heavy smoker and she develops emphysema and is no longer able to travel.
Her Buy-Sell agreement was in place and she was insured under the Buy-Sell Disability Income insurance policy. Since Marie was not a programmer or accountant, she had no real value to the company and being unable to perform her job, the company bought her interest out and received benefits from her policy. In the meantime, Marie found that she had a natural talent for tele-marketing, and went to work for a telemarketing company as a supervisor (with her emergency oxygen tank at the ready). She could perform this other job for another employer and her previous employer would still receive benefits.
This section defines when the buy-out expense benefit is payable, and the conditions applying to the payment of such benefits. Note that in this wording, “You” and the “Insured” are not the same.
The available methods of funding the buy-out are indicated on the policy schedule, but all available funding methods are shown. The policyowner chooses the method that they prefer. The funding can be by equal monthly payments, or with the first payment being larger as a down payment and the remainder on a monthly basis, or a lump sum payment may be specified. Another option is for the funding to be paid in equal and guaranteed installments.
“Each month, We will pay the actual Buy-Out Expense incurred, but not more than the Monthly Benefit Limit shown on the Policy Schedule.
The total of all monthly benefit payments will not exceed the lesser of the total Buy-Out Expense or the Aggregate Benefit Limit.
If the Insured dies, benefit payments under this section will stop as of the date of death.”
Funding by Down Payment
“We will pay the actual first Buy-Out Expense but not more than the Down Payment Benefit shown on the Policy Schedule.
Each month after that, we will pay the actual Buy-Out Expense incurred, but not more than the Monthly Benefit Limit shown on the Policy Schedule.
The total of all payments described above will not exceed the lesser of the total Buy-Out Expense or the Aggregate Benefit Limit.
If the Insured dies, benefit payments under this section will stop as of the date of the death.”
“We will pay the actual Buy-Out Expense but not more than the Lump Sum Benefit Limit shown on-the Policy Schedule.
In lieu of this Lump Sum payment, You may request that the benefit be paid in equal, guaranteed installments over a period not to exceed ten years. We must mutually agree to (a) the method of payment; (b) the time over which it will be paid: and (c) the amount of interest that We will pay periodically on the declining balance.”
Most, if not all, of the Disability Income insurance policies make a payment to the policyowner if the insured dies. Typical wording is as follows:
“If the monthly benefit payments stop because of the death of the Insured, We will pay an amount equal to (usually two) times the Monthly Benefit Limit. This benefit is not part of the Aggregate Benefit Limit. This provision does not apply to Lump Sum Funding” [obviously].
Legal and accounting fees are incurred anytime that a Buy-Sell agreement is used. The policy does not pay for legal or accounting fees for drawing up the agreement originally, only when it is used when disability (or death) is incurred.
“We will pay up to $2000 for legal and/or accounting fees incurred to perform the Buy-Sell Agreement. This benefit is not included in the Aggregate Benefit Limit. It is payable as of the Commencement Date or, if later, the date a Buy-Out Expense is incurred.”
This is standard in Disability Income insurance policies. For a Buy-Sell arrangement where the policyowner (designated as “You”) is different than “Insured.”
“After the Insured has been Totally Disabled for 90 days, We will waive any premium that becomes due while the Insured remains Totally Disabled. Your Policy and its benefits will continue as if the premium had been paid.
We will also refund any premium that became due and was paid during those first 90 days of Total Disability.”
As discussed earlier, this policy allows for transfer of coverage under certain conditions, but not until the policy has been in force a stipulated period of time – typically two years. Coverage can be transferred to a new owner if the insured leaves the company and starts a new business and no evidence of insurability is required.
“{After this Policy has been in force for two years, coverage may be transferred to a new owner, if all of the following conditions are met:
a. The Insured ends Active Full-time Employment with the business entity.
b. The Insured is under age 58.
c. The Insured is not Totally Disabled and has not received benefits under this Policy.
d. The Insured begins full-time work in a business or profession in which he does not own more than a 90% share or less than a 10% share.
This transfer must be applied for within 90 days after this Policy ends due to the Insured ending Active Full-time Employment with the business entity.
The amount of coverage will be based on the value of the Insured's share of the new business entity but it cannot exceed the Aggregate Benefit Limit for this policy.
Evidence of the Insured's health will not be required.”
Provisions are made for a situation where an insured may wish to own the policy because the insured becomes more than a 90% owner of the business. The correct policy form in that case would be a loss of time type of policy.
“This policy may be exchanged for a disability income policy covering the Insured, if this Policy is not renewed because the Insured becomes more than 90% owner of the business entity. The exchange must be requested in writing. It can only be made before the Insured's 60th birthday and while this Policy is in force.
The following apply to the new policy:
a. The monthly benefit cannot exceed an amount, which, if added to the Insured’s disability benefits from all sources, would exceed the maximum monthly benefit We offer to new applicants on the date of the exchange, but the monthly benefit cannot exceed $1000.
b. The benefit period will be 24 months and disability benefits cannot be payable before the first day of total disability.
c. The premium will be based on our rates in effect on the date of exchange for the Insured's attained age on that date; however, the Insured's rate class will be the same as for this Policy.
d. The new policy will only cover disability or other loss, which begins after the new policy, takes effect. The new policy can only exclude any condition excluded by this Policy.
e. The owner of the new policy will be the Insured.”
This is usually the only exclusion in this type of policy.
“We will not pay benefits for disability due to act or accident of war, whether declared or undeclared. ”
As with most health insurance products, notice to the insurer of any pre-existing conditions is mandatory. Usually there is no time limit shown as to a reportable condition prior to the application. If a pre-existing condition has not been listed on the application, any disability as a result of the not-reported pre-existing condition. Any reported pre-existing condition that has been reported and specifically excluded by the policy will not, of course, be covered as a cause of disability.
“We will not pay benefits for a Pre-existing Condition if it was not disclosed on the Application. Pre-existing Condition means a Sickness or physical condition for which prior to the Date of Issue:
a. Symptoms existed that would cause an ordinarily prudent person to seek diagnosis, care or treatment; or
b. Medical advice or treatment was recommended by or received from a Physician.
Also, We will not pay benefits for any loss We have excluded by name or specific description.
Obviously, losses must occur only while the policy is in force but if the policy is terminated while there is a disability claim, it will be covered as stipulated.
“All losses must occur while Your Policy is in force. But termination of Your Policy will not affect any claim for disability that begins within 30 days of the date of an Injury causing such disability.”
All claims must be written, as in most (if not all) insurance policies.
“Written notice of claim must be given to Us within 30 days after a covered loss starts or as soon as reasonably possible. The notice will be sufficient if it identifies You and the Insured and is sent to Our Home Office or is given to Our agent.”
Claims forms are “proof of loss” forms but a written statement as to the nature and extent of the loss will suffice.
“After We receive the written notice of claim, We will send You Our proof of loss forms within 15 days. If We do not, You will meet the written proof of loss requirements if You send Us, within the time set forth below, a written statement of the nature and extent of Your loss.”
The proof of loss must be sent within a time frame, usually 90 days, after an insured period, but there is leeway granted (usually as the result of state insurance laws) but there still is a requirement that written proof must be given within a year of occurrence unless the insured is physically unable to submit proof.
“Written proof of loss must be sent to Us within 90 days after the end of a period for which We are liable. If that is not reasonably possible, Your claim will not be affected. But, unless You are legally incapacitated, written proof must be given within one year."
In keeping with state insurance laws, benefits must be paid promptly after “satisfactory” proof of loss. Unfortunately, in some few situations, the word “satisfactory” can mean extended investigation into the claim. Also, “subject to continuing proof of loss” allows the insurer to reinvestigate periodically and to withhold payment until the claim has been reinvestigated to the satisfaction of the insurer.
“After We receive satisfactory written proof of loss:
a. We will pay any benefits then due that are not payable periodically; and
b. We will pay at the end of each 30 days any benefits that are payable periodically, subject to continuing proof of loss.”
Benefits are always paid to the policyowner unless a loss payee has been named to receive benefits, and agreed to in writing by the insurer
The insurer always has the right to have the insured undergo a physical examination as “reasonably required” while is a claim is continuing. The definition of the word “reasonably” can and has been open to court interpretation. Usually, there is little problem with this provision, especially since the insurance company pays for the physical examination.
If the Insured's age has been misstated, the benefits under the Policy will be those that the premium paid would have purchased at the Insured's correct age. Universally used.
Nothing unusual here. The first premium is payable on the issue date and thereafter according to the mode of payment as specified in the policy (and agreed to by the insurer and the policyowner). Premiums can be paid to the company or to the agent in most cases. The mode of payment may be annually or semi-annually, with quarterly or monthly premiums allowed only with permission of the insurer – quarterly and monthly add to the administrative cost and approval would be limited to the larger premium payments. Changes in mode can be made but no changes are allowed while the insured is disabled.
After the first premium has been paid, a grace period of 31 days is allowed for late payment of premium. If premium payments are not made when due or within the Grace Period, Your Policy will remain in force during the grace period.
If the premium is not paid when it is due or within the grace period, the Policy will lapse.
Typically with insurance policies, if the policy lapses because of non-payment of premium when due or if it is paid after the grace period, it will be reinstated if the company or the agent accepts premium payment, even if a reinstatement application is otherwise required.
If premiums are received at the home office of the insurer with a stipulated period of time (one company uses 57 days-) then evidence of insurability is not required. After that period of time, a reinstatement application must be completed and a conditional receipt will be issued. If the application is approved, the reinstatement will be effective the date of approval. If the application is disproved, the insurer must notify the insured in writing within 45 days of the conditional receipt. If the insurer forgets or neglects to notify the insured, the policy will be reinstated automatically on the 45th day.
The reinstated Policy will cover only loss due to:
a. Injury sustained after the date of reinstatement; or
b. Sickness that begins more than ten days after such date.
There is always a legal statement that the policy with application and any attached papers, riders or forms, constitutes the entire contract and no change in the contract can be made unless approved by an officer of the insurance company. Agents may NOT make any changes or waive any provisions of the policy.
In compliance with state statutes, after the policy has been in force for two years (excluding any time during which the insured was disabled) the insurance company cannot contest the statements in the application. Further, during the two-year period, the insurance company cannot reduce or deny a claim because a sickness or physical condition that had existed prior to the date of issue of the policy.
Standard wording which specifies that any provision in the policy that conflicts with laws of the state, in which the insured resides, is hereby amended to conform to the minimum requirements of such laws.
Legal action cannot be brought within 60 days after written proof of loss is given or after three years from the date the written proof of loss is required. This is typical in insurance contracts for the obvious purpose of keeping a claim from dragging on and on and on…
The income tax treatment of Key Employee disability income insurance and disability buy-out insurance is the same as that for personal coverage, i.e., premiums are not deductible and benefits are received tax-free. Premiums paid for overhead expense insurance are usually deductible by the business as a business expense. This would mean that the benefits would be considered as ordinary income, but they may be offset by the business expenses that the policy benefits are designed to cover.
A corporation is a business entity that is vested with a completely separate tax and legal status that is apart and separate from the owners. A shareholder becomes an “owner” and the largest companies are corporations, some with thousands of owners.
A corporation is created by law and has authority under law to act as a single person, distinct from the shareholders that own it, and it has rights to issue stock and exist indefinitely. See previous chart). An often-quoted legal decision (Trustees of Dartmouth College v. Woodward, 17 U.S. [4 Wheat.] 518, 636 [1819] (Marshall, J.) states: “A corporation is an artificial being, invisible, intangible, and existing only in contemplation of law…. [It} possesses only those properties which the charter of its creation confers upon it.”
There are many types of corporations, but for purposes of this discussion, a general type of corporation and a close-corporation are of interest.
Because a corporation is a legal entity, the shareholders (stockholders) are not personally liable for the debts of the corporation (unless there is fraud, of course). Therefore, the liability of the stockholder is limited to their initial capital investment (plus any subsequent investment). Professional corporations are a little different inasmuch as a professional is subject to liability because of malpractice.
The corporation is taxed separately under separate federal and state tax regulations. There is a federal exception – certain corporations may elect to be taxed similarly to partnerships and are known as “S” or “Subchapter S” corporations.
A Close Corporation (closely-held corporation) is a corporation whose stock is not freely traded and is held by only a few shareholders – often with the same family. The legal requirements and privileges of Close Corporations vary by jurisdiction. They may be also referred to as Closely-held Corporations, or Closed Corporations.
Even though a Close Corporation may be run much like a partnership, the limited liability for the shareowners (stockholders) and the corporation’s legal status as a corporation or legal entity, differentiate it from a partnership. In the discussion of Disability Income insurance, however, a Close Corporation is treated much like a partnership – one reason being that most Close Corporations started as a partnership. “Partnership” usually means a few owners, whereas “Corporation” usually indicates many owners. In case of a disability of an owner it is easier for the business to replace one owner if there are, for instance, ten owners as the risk is dispersed more widely. However, if there are only a very few owners, whether partner or shareholder, then it is more difficult to replace the owner.
However, the risk of disability become greater as the group becomes larger. According to statistics published by the NAIC (1986 Commissioners Disability Table), as shown below, the probability of at least one Long-term disability (disability lasting 90 days or more) increases.
PROBABILITY OF AT LEAST ONE LONG-TERM DISABILITY PRIOR TO AGE 65
Number of persons in the group
25 21.4% 38.3% 51.5% 61.9%
30 20.7% 37.0% 50.0% 60.4%
35 19.9% 35.8% 48.6% 58.8%
40 18.9% 34.2% 46.6% 56.7%
45 17.5% 31.9% 43.8% 53.7%
50 15.5% 28.6% 39.6% 49.0%
55 12.4% 23.3% 32.8% 41.1%
Another pertinent point is that the problems of any business entity, that of replacing the disabled owner, paying double salaries, etc., exists regardless of whether it is a corporation or a partnership, but what will happen if more than one owner (partner, shareholder) is disabled?
In case of permanent disability of a stockholder-employee, where will the corporation get the funds to purchase the stock of the disabled stockholder? Many other questions will also arise, such as valuing the worth of the business at time of disability, etc. Most of these are discussed and addressed in this text.
Upon the disability of a major shareholder in a closely held corporation, there are a few alternatives for the other shareholders. Primarily, they could possibly pay dividends to the disabled shareholder that approximates the salary of the disabled shareholder, freeing up his salary for replacement purposes, or purchase the stock from the disabled owner.
The first alternative would not be welcomed by the other shareholders as they would be working harder to perform the duties previously performed by the disabled stockholder, but they would still share the results of the their hard work, but with a shareholder who is contributing nothing but his capital to the company. If the working shareholders reduce the dividends, it is possible that they could be subject to a lawsuit – or at least they would have a disgruntled shareholder.
The disabled majority shareholder would be in a tough situation, as he would either have to sell his stock to the minority stockholders or to an outside party(s) – neither of which would feel any obligation to offer a fair market value for the stock. The minority stockholders may not have sufficient funds to purchase the interest of the disabled majority shareholder. Even if they were able to come up with enough money to buy out the disabled shareholder, the minority stockholders might just want to take the money and start a new business – leaving the disabled majority shareholder “holding the bag,” with majority stock in a depleted business.
One other important consideration when looking for outside investments. An outsider will rarely offer anywhere near the value of the stock because the remaining stockholders could resign if they weren’t happy with the deal.
Since a large part of the Disability Income insurance market is with professional persons, and in particular the medical field, it is quite common for a professional organizations to be a “P.A.” or “Professional Association.” Theoretically, a P.A. is a group of professionals organized to practice their profession together, through not necessarily in corporate or partnership form. Therefore, legally and for liability and tax purposes, a P.A. may be a corporation, proprietorship or partnership. Therefore, for Disability Income purposes, they should be treated as whatever business entity they have legally accepted. For malpractice insurance purposes and other reasons, most P.A.s operate as sole proprietors.
The problems of disability for a professional practice are very similar to those of sole proprietors but with added problems. A business owner spends business capital on inventory and equipment – tangibles for the most part – a professional, such as doctors, dentists, CPAs, etc. – must work for years before they can recover the costs of their education and technical training, and start showing a profit. There also is the problem that if a professional becomes disabled, in most cases it is very difficult, if not impossible, to find a replacement. And even with a disability, there would likely be pressure to keep the office open from customer/clients/patients and from employees. There is a lot at stake for a professional and that is principally why most professional persons are vitally interested in Disability Income insurance.
The problems of the minority (or equal, i.e., 50/50) stockholders have legal rights and even though they may not be able to control the company per se, they can cause a lot of headaches and make life miserable for surviving stockholders. In fact the minority stockholders may well be the ones who understand the business better than the majority stockholder and are the ones who can continue the business on an ongoing profitable basis.
However, practically speaking, the minority stockholder that becomes disabled is in an unenviable bargaining position as few would purchase a minority interest in a closely held corporation – and if there were an interest, such as a competitor, the disabled stockholder would not be in a position to hold off an unfriendly takeover, which it what it could be. They would also not receive any income from their investments as rarely does a closely held corporation issue dividends.
These problems can be avoided by establishing Buy-Sell agreement properly drawn, either the Entity (also called Stock Redemption when it involves corporations) or the Cross-purchase plan as described in the partnership application of these agreements.
The agreement binds the remaining stockholders (non-disabled) or the corporation (if a Stock-redemption plan) to buy the stock of the disabled stockholder at an established price as set forth in the agreement. Further, it obligates the shareholder to sell his stock to the surviving stockholders (under a Cross-purchase plan) or to the corporation (Stock Redemption plan). The value of the stock is determined when the contract is drawn up and may be either a flat amount or a percentage of the net worth or some other generally accepted accounting principal might apply. These agreements should be reviewed periodically as the value of the company changes.
The shareholders in a closely held corporation are in a similar position to that of partners in a partnership and the possibility of a working stockholder (owner) becoming disabled is a very serious risk for the business. The best solution is to fund the Buy-Sell agreement with appropriate amounts of disability insurance.
Most Disability Income insurance companies have “fact sheets” for buy-out of a business which require the name of all of the owners, their age, title, annual income from the business, and percentage of ownership. Other pertinent questions are asked, such as current fair market value of the business, total purchase price in the agreement and the basis used to determine the value.
Information regarding any financial difficulties of the business, such as receivership, bankruptcy, or other failures of the business over the past few (usually five) years must be provided.
If all of the owners are not applying for coverage for the Buy-Sell agreement, those that do not participate are identified and the reasons they are not participating are outlined. Also, any Disability Income insurance owned by any of the business owners must be declared in detail.
F For a Stock-redemption agreement in particular, the Buy-Sell agreement consists of multi-pages, very detailed and very “legalistic.” It is imperative that an attorney be involved in preparing this document.
Premiums paid for Disability Income insurance under the corporate Buy-Sell agreement, whether Cross-purchase or Stock Redemption, are not income tax deductible. Disability payments are not usually taxable.
The tax bracket of the corporation has a lot to do with determining the type of Buy-Sell agreement. If the corporation is in a lower tax bracket than that of its shareholders, the Stock Redemption plan would probably be preferred as the premium payments on the insurance should, in this situation, take a smaller share of the corporation’s income (after-tax) than it would of the shareholders’ income (after tax).
On the other hand, if the stockholders are in a lower tax bracket than the corporation, the Cross-purchase plan may be best as the situation is reversed from above, i.e., the shareholders’ after-tax income would take a smaller bite than the corporation’s after-tax income.
In respect to administration, if there are only two stockholders, there is little difference between the two plans in the cost and efficiency of the administration. In either case, there will be two policies issued. But if there are a number of stockholders, the difference can be dramatic. Under a Stock Redemption plan, the company only needs to purchase one policy per shareholder. However, under the Cross-purchase plan, each shareholder would have to purchase a policy on each of the other shareholders. If this doesn’t seem like a problem, consider the fact that if there were only 5 stockholders, there would have to be 20 policies issued. If there were 10 stockholders, there would have to be 90 policies! (There is a formula for this : n(n-1), where n is the number of stockholders.)
Another factor to be considered is the effect of the plan on the cost basis of the stock. With the Stock Redemption type of Buy-Sell agreement, the corporation buys the stock from the disabled stockholder, and the stock then becomes “treasury” stock and is no longer outstanding stock. Therefore, the other stockholders keep their original stock with no increase in the cost basis of the stock, even though each stockholder now owns a larger percentage of the total stock of the corporation (which translates into a larger percentage of ownership).
This is, of course, a desirable situation, however if they sell their stock, the taxable gain will be increased by the increase in the larger ownership of total stock and percentage of ownership.
With a Cross-purchase plan, the surviving (non-disabled) stockholders buy the stock with their own money, so they receive an increase in basis equal to what they have paid for the new stock. In a later sale of the stock, this new basis reduces the amount of taxable gain realized by the stockholder selling the stock.
This outcome is important if stock is sold during the lifetime of the stockholder – as in the case of disability. If the stockholder (disabled stockholder in this case) keeps the stock until his death, the stock will then have a stepped-up basis to its fair market value on the death of the stockholder. In this case the result would be the same, regardless of type of agreement. What has entered into this equation is capital gains taxes. Capital gains would be the difference between the sale price of the stock less the cost basis. With capital gains presently around 20%, this could be significant. Watch the news, however, as there is serious consideration given to reducing capital gain taxes even more, or even doing away with them entirely.
A problem may arise in respect to the accumulated earnings penalty tax on corporations that applied in those situations where the corporation accumulates earnings and profits that are more than what is needed for legitimate business purposes and thereby preventing this excess amount from being taxed to the shareholders. This tax is rather punitive, as it is taxed at the corporation’s regular tax rate, plus 28 percent. There is a cushion of $250,000 that may be accumulated for any reason, and the tax will be applied to that amount.
Several court cases have agreed that accumulating funds to buyout a minority stockholder is a legitimate business expense when the funds are used to promote the management efficiency of the company. There are disagreements among the courts as to whether this would apply to the accumulation of funds to buy out a majority stockholder. In any event, this problem is eliminated if the Buy-Sell agreement is a Cross-purchase plan, as the stockholders and not the corporation own the policies.
If the accumulated earnings penalty is the principal reason that the Cross-purchase plan is used, when for other purposes, the Stock Redemption plan is better, one alternative would be to carry Key Employee insurance on the shareholder instead of obligating the corporation to carry insurance on the shareholder. Insurance purchased to indemnify the corporation for loss of a Key Person’s service has been held by the courts to be a reasonable business need, and further, any funds held by the corporation for this purpose should not be eligible for the accumulated earnings penalty tax. Note, however, that the published court cases usually refer to life insurance as the insurance vehicle to furnish funds to purchase the stock in case of death of the stockholder, and while logically, it would seem to extend to Disability Income insurance also but if the situation arises, further legal information on this matter should be obtained.
Under the Cross-purchase plan, the policies are not owned by the corporation, so creditor-corporation problems do not arise. Under the Stock Redemption plan, the policies are owned by the corporation and are part of the assets, and subject to attachment by creditors.
Since most Close Corporations carry a line of credit, the loan agreements used by most banks contain provisions that prohibit the corporation from paying dividends or redeeming stock without the prior and express consent of the lending institution. Therefore, a Stock-redemption agreement could not survive without being fully funded and any indebtedness satisfied to avoid the problem of the creditors objecting to the Stock-redemption. This does not arise in a Cross-purchase agreement.
As mentioned earlier, capital gains taxes result if the corporation redeems the entire stock of a stockholder, whereas a partial redemption will cause dividend treatment, which is not good. Therefore, most Stock Redemption plans are plans that redeem all of the stock of the disabled stockholder.
There may be problems in some family-owned or similar type of corporations, as the attribution rules in effect the stock owned by family members would be attributed to the stockholder, and any stock transferred to other family members because of the (death or) disability of the stockholder, would be attributed to that of the remaining (surviving) family member as dividends, an unfavorable treatment.
This rule can be waived if the stockholder that owned the stock that is being redeemed (in this case, the disabled stockholder) agrees that he will not retain any interest in the corporation immediately after the redemption (with the possible exception of a creditor); he will not obtain or acquire any interest in the corporation within 10 years of the redemption (except by bequest or inheritance); and he files an agreement with the IRS that he will notify the IRS if he should obtain an interest within the 10 year period that is in violation of the above agreement.
Under a qualified employee Stock Ownership plan designed to purchase the employer’s stock, if stock in the corporation becomes available after a business-continuation plan has been invoked, it is feasible that the employee Stock Ownership plan could purchase this stock as it is made available. Actually, the employee Stock Ownership plan could enter into an agreement with one or more of the stockholders or business owners whereby they could purchase any stock made available because of the disability of one of the stockholders. The employee Stock Ownership plan can purchase insurance to fund this purchase. This arrangement is generally used when stock becomes available because of the death of a stockholder, and the funding is by life insurance but there seems to be no reason that the same arrangement couldn’t be used for disability of the stockholder.
STUDY QUESTIONS
1. The purpose of a disability Buy-Sell agreement insurance policy is for the insurer to pay benefits as provided in the policy for the purpose of reimbursing the policy owner with funds actually paid to
A. pay attorney’s fees and other such expenses.
B. to pay for medical care for the disabled partner in excess of his health insurance.
C. buy the disabled insured’s entire ownership interest in the business Entity.
D. pay for outstanding business expenses at time of disability.
2. A document-contract between the insured and the policy owner that calls for the purchase of the insured’s entire ownership in the business entity in the event of the insured’s total disability, is
A. a Buy-Sell agreement.
B. a Disability Income insurance contract.
C. an Entity agreement.
D. a cross-purpose purchase contract.
3. Benefits under a Buy-Sell arrangement Disability Income policy may NOT be paid
A. by monthly funding.
B. by funding a large down payment and the remainder by smaller level payments.
C. by payment of a lump sum.
D. by issuing a promissory note refundable when the business is sold to outside parties.
4. A Buy-Sell Disability Income policy will reimburse for legal or accounting fees incurred
A. to draw up the Buy-Sell agreement.
B. to “perform” the Buy-Sell agreement.
C. in drawing up incorporation papers if the business entity changes.
D. in defending any liability claims for the disabled insured.
5. After an insured has been disabled according to the policy definitions, for a period of 90 days (typically), he does not have to pay any additional premium during his disability, and
A. if he remains disabled for 2 years and returns to work, premiums are still waived.
B. any premiums paid during the waiver period will be refunded.
C. half of the premium paid during the waiver period will be refunded.
D. the benefits will be enlarged to include interest on the waived premium.
6. Joe applied for an insured disability claim. The insurer insisted that he have a physical exam.
A. This is totally unnecessary and Joe can refuse and still get his benefits.
B. The company always may make a reasonable request for a physical examination.
C. Joe would have to pay for the physical examination.
D. The agency would be charged back for the cost of the physical examination.
7. The income tax treatment of Key Employee disability income insurance and disability buy-out insurance is the same as for personal coverage, i.e.,
A. premiums are not deductible and benefits are received tax-free.
B. premiums are deductible and benefits are received tax-free.
C. premiums are usually deductible by the business as a business expense.
D. the business pays taxes on the premiums, the insured pays taxes on the benefits.
8. In business use of Disability Income insurance on the corporate level, as a group becomes larger,
A. the risk of disability increases.
B. the risk of disability decreases.
C. the risk of disability stays the same.
D. Disability Income insurance becomes more impractical.
9. If a majority stockholder in a business becomes disabled, and he does not have Disability Income insurance, which of the following would be most likely?
A. He is in a bad situation, he either has to sell his stock to minority stockholders or outside party, neither of which would probably offer a fair price for the stock.
B. There is no problem, as the company can issue new stock to buy out his interest.
C. He could force the minority stockholders to buy him out or be fired.
D. There is not any difficulties as he can still draw an income and the company goes on.
10. One of the big advantages of a Cross-purchase plan with a corporation over a Stock-redemption plan is
A. creditor problems do not arise as the policies are not owned by the corporation.
B. the Stock-redemption plan is illegal in many states.
C. the Cross-purchase plan could not survive without being fully funded and indebtedness satisfied to avoid the creditors objecting to the Cross-purchase plan.
D. that a Cross-purchase plan does not need to be drawn up by an attorney – they should not even get involved.
ANSWERS TO STUDY QUESTIONS
1C 2A 3D 4B 5B 6B 7A 8A 9A 10A