In business, there are many types of buy-sell agreements to protect owners, the business, partners, shareholders, or family members. When one person owns a company with no other interested parties, they are considered a sole proprietor. If this person becomes permanently disabled, the business’ only owner would then be unable to run the business.
Therefore, when a sole proprietor is making plans for the future, the key employee disability insurance concerns should lead them to consider disability insurance in the chance that they become unable to continue working before retirement.
Buy-Sell Agreement Cross Purchase
There are many different mechanics or characteristics of a disability buy-sell plan, such as the amount of the policy, which insurance company to use, and who will ultimately purchase the business.
The first step in planning for a disability for a sole proprietor is coming to an agreement with the purchaser. For example, if a business owner wishes to receive $500,000 for the company and there is a purchaser that agrees to that amount, a buy-sell agreement will be entered into by both parties. This agreement states the amount the business will be purchased for in the event that the sole proprietor becomes disabled and unable to continue working.
Then, the purchaser finds an insurance company to purchase the disability buy-sell insurance where the premiums are nondeductible. This business disability buyout policy must be for at least the agreed upon price for the sale of the business.
Next, the sole proprietor purchases disability buyout insurance, also known as a disability buy-out policy, for the agreed upon amount—in this case, the amount would be $500,000. The buy-sell agreement insurance would name the sole proprietor as the insured, the purchaser as the beneficiary and the owner.
If the sole proprietor becomes totally and permanently disabled, the buy-sell agreement insurance proceeds are received by the sole proprietor as an income tax-free lump sum or in income tax-free installments. These payments are received from the purchaser who is the policy holder of the buy-sell agreement insurance.
Finally, the purchaser uses the proceeds of the disability buy-out policy to buy the disabled sole proprietor’s business for the purchase price agreed upon in the buy-sell agreement. The purchase price is paid in a lump sum or in installments, as specified in the agreement.
Other Features of an Insured Disability Buy-Sell Plan
In addition to serving as a source of funding, an insured disability buyout plan features a variety of other functions:
- It is recommended that the disability buy-sell definition be the same in the insurance contract and the buy-sell agreement.
- If the disability buyout insurance definition is the same, the payment of the insurance proceeds needed to purchase a disabled owner’s business interest is prompt and certain.
- The payment is triggered when the event creating the need for cash—a sole proprietor’s total disability—arises.
- The business disability policy provides the dollars for the purchase of the business interest at the uncertain time of the owner’s disability.
- Disability buyout insurance proceeds can be payable in a lump sum, in installments, or in a combination of both.
- If the disability buy-sell insurance proceeds exceed the total premiums paid, this gain is generally received free of income tax. For example, if a total of $100,000 has been paid on a $500,000 disability buy-sell policy when the owner becomes totally disabled, then the $400,000 is received income tax-free.
- A disability buy-sell insurance policy avoids the problems associated with other methods of financing the purchase of a business interest at the total disability of a sole proprietor.
- A waiting period of 12 to 36 months is selected in order to reasonably assume that the disabled owner will be unable to return to work. This waiting period can be used to trigger the buy-out after the total disability has been determined.
- During this waiting period, the disabled owner’s salary can be continued through a salary continuation plan funded with disability income coverage.
- In addition to disability, provisions can be included in a buy-sell plan that covers the purchase of an owner’s business in the event of death or retirement.
Summary of Insured Disability Buy-Sell Plan Tax Results
Premium payments for disability buy-out insurance are not tax deductible, whether an individual owner or the business pays for them. However, the proceeds received after a disability are income tax-free, meaning that a policy owner may pay only a portion of the premiums before receiving the proceeds. Only the total disability of the sole proprietor will dictate the amount of premiums paid and the amount of proceeds received income tax-free.
Generally, disability buy-out policy proceeds are not subject to regular income tax, as mentioned above. However, when these proceeds are paid to a corporation, they may be subject to the corporate alternative minimum tax.
Capital gains taxes may have to be paid by the sole proprietor or the sole proprietor’s estate after the transfer of the business interest is exchanged for the disability buy-out proceeds. However, the disabled owner is subject to the payment of taxes at capital gains rates only to the extent that the purchase price exceeds the value of the business.
In a partnership or corporation cross purchase buy-sell agreement, the remaining active owners’ tax basis is increased by the amount of the purchase price.
Finally, in a partnership entity purchase or corporation stock redemption buy-sell agreement, the remaining active owners receive an increased ownership share of the business, but not an increase in their tax basis. The partner who has sold their portion of the interest is subject to capital gains taxes, but only for the amount that exceeds their portion of the business.
The guarantees of receiving payment is subject to the claims-paying ability of the issuing insurance company.
With so many different aspects of a buy-sell agreement, it is wise to seek the advice of a financial expert or a trusted financial advisor before making any decisions pertaining to retirement, disability, or death insurance.