How small business owners can use disability insurance to fund a buy-sell agreement
My firm, Lasting Wealth Principles, does not sell any insurance products, but I still believe that disability insurance is a particularly important wealth protection tool, especially for small business owners. Deciding on the type and amount of disability insurance to purchase depends on an individual’s specific financial situation and goals. As I go through the insurance planning part of my financial planning process with small business owner clients, I evaluate whether a buy-sell agreement is applicable (e.g., shared ownership of business with one or more people) for them and if disability insurance is the most efficient way to fund it. The purpose of a buy-sell agreement is to provide instructions on what the owners will want to happen with the business if an owner exits the business (e.g., death, disability, or retirement). Using disability insurance to fund a buy-sell agreement provides a smooth transition of ownership and business continuity in the event of a disability.
Cross-Purchase Agreement
One of the more common buy-sell agreements used by small business owners is a cross-purchase agreement where each owner will purchase a disability insurance policy. In the event of an owner becoming disabled, the other owner(s) are contractually obligated to use the disability insurance benefit to purchase the disabled owner’s share of the business. I illustrate a hypothetical example below.
John and Mary are co-owners (each own 50%) of a small business consulting firm (currently valued at $1.5million) who both have agreed that they would like their ownership in the business protected if one of them becomes disabled. To accomplish this objective, they meet with an attorney to set up a cross-purchase agreement where both John and Mary agree to purchase the other’s ownership if one becomes disabled. Additionally, John and Mary both purchase disability insurance policies that are structured to pay a monthly benefit of $12,500 for a maximum benefit period of five years in the event of a total disability. If John or Mary become disabled, then the following would occur.
The disability insurance policy of the disabled owner starts to pay a monthly benefit of $12,500 (after the elimination period stated in the policy).
With the monthly benefit of $12,500 from the disabled owner’s policy, the other owner uses these funds to purchase the ownership of the disabled owner over the course of five years. The calculation of the purchase is $12,500 per month for 60 months, which totals $750,000 (50% of $1.5 million valuation).
As a result, ownership would have been transitioned smoothly and either John or Mary now can continue operating the business consulting firm without disruption. Most importantly, the disabled owner would receive the appropriate financial support through compensation for their ownership (via disability insurance benefits) during a challenging time of disability.
Entity-Purchase Agreement
Another type of buy-sell agreement that can be used by small business owners is an entity-purchase agreement where the business entity purchases disability insurance policies on each owner. If an owner becomes disabled, then the business entity is contractually obligated to use the disability insurance benefit to purchase the disabled owner’s share of the business.
Other considerations
Every small business is unique so buy-sell agreements should be customized to reflect the specific circumstances and objectives of the business owners involved. Since disability insurance can be complex in certain situations, it would be beneficial to work with legal and insurance professionals experienced in this area to ensure that the agreement is in line with the business's overall goals.
It is also prudent to periodically review buy-sell agreements that have been put in place to address the potential change in the circumstances of the business, which could include changes in ownership and/or business valuation. Making sure the business valuation is up-to-date and accurate ensures that a disabled owner would get the appropriate monetary value. For example, if a business of two equal co-owners is valued at $1.2 million, then each owner’s disability insurance policy would have to have a benefit that totals $600k (e.g., $10k monthly benefit over the course of five years), but if the business significantly grew in value over many years to $2.4 million, then each disability insurance policy’s benefit would total $1.2 million instead ($20k monthly benefit over the course of five years). Note that increasing disability insurance coverage could require additional underwriting requirements, which might be an issue if the insurance company does not provide a favorable offer (i.e., lower premium to pay). Also, there are companies (used by fee-only, financial planners to help clients obtain the best insurance solution for their situation) that can assist small business owners by providing them with the most accurate insurance quotes and multiple insurance carrier options (i.e., companies with high ratings that meet strict guidelines and standards). Having multiple options gives small business owners the flexibility to choose the disability insurance policy that best fits their needs and budget.