Disability Buy-Out Agreement Funded by Life Insurance: A Guide for Business Partners

 

If you are a business partner, you may have invested a lot of time, money, and effort into building your company. But have you thought about what will happen to your business if you or one of your partners becomes disabled and unable to work? Who will take over the disabled partner’s interest and how will they pay for it? How will the disabled partner be compensated for their hard work and sacrifice? These are some of the questions that a disability buy-out agreement can help you answer.

A disability buy-out agreement is a type of buy-sell agreement that specifies how a disabled partner’s interest in the business will be bought out by the remaining partners or the business itself. This agreement is typically funded by life insurance, which ensures that funds are available in the event of a partner’s total disability. In this article, we will explain what a disability buy-out agreement is and how it works. We will also discuss the benefits of funding a disability buy-out agreement with life insurance and how to set up one for your business.

Disability Buy-Out Agreement: A Definition and an Example

A disability buy-out agreement is a legally binding contract between business partners that predetermines the terms of buying out a disabled partner’s interest. This agreement is usually part of a broader buy-sell agreement that covers other triggering events, such as death or retirement. In a disability buy-out agreement, the partners agree on the definition of disability, the valuation of the business and each partner’s share, the price and terms of payment, and the rights and obligations of the parties.

For example, let’s say you own 40% of a company with two other partners, who each own 30%. You have a disability buy-out agreement that values the company at $5 million and defines disability as being unable to perform your duties in the business for more than 12 months. You also have a $2 million life insurance policy on your life that is owned and paid by the business.

If you become totally disabled and unable to work in the business for more than 12 months, the business will receive $2 million from the life insurance policy. The business will then use that money to buy your 40% share from you or your representative for $2 million, as per the agreement. The remaining $3 million will be divided equally between your two partners, who will each own 50% of the company after the buyout. You will receive $2 million in cash for your share of the business, without having to deal with any legal or financial hassles.

A disability buy-out agreement is different from other types of buy-sell agreements, such as death or retirement buy-sell agreements. In a death buy-sell agreement, the triggering event is the death of a partner, not their disability. In a retirement buy-sell agreement, the triggering event is the voluntary or involuntary retirement of a partner, not their disability. However, some buy-sell agreements may combine different types of triggering events and provide different terms and conditions for each.

Benefits of Funding a Disability Buy-Out Agreement with Life Insurance

Funding a disability buy-out agreement with life insurance is a common and effective way to ensure that there is enough money to complete the buyout when a partner becomes totally disabled. Life insurance provides liquidity and certainty at the time of a triggering event, which can be beneficial for both the business and the partners’ families. Some of the benefits of using life insurance to fund a disability buy-out agreement are:

• Tax-free disability benefits: The proceeds from a life insurance policy are generally income tax-free to the beneficiary. This means that the business or the remaining partners can use the full amount of the disability benefit to pay for the buyout without having to worry about taxes. However, there may be some exceptions or limitations depending on the type and structure of the policy and the entity. For example, a C corporation may be subject to the alternative minimum tax (AMT) on some portion of the disability benefit.

• Quick and easy settlement of the buyout: Life insurance proceeds are usually paid quickly after the disability of the insured person, ensuring that the buyout can be settled in a timely manner. This can prevent any delays or disputes that could disrupt the business operations or affect the value of the company. It can also provide immediate cash to the disabled partner, who may need it to pay for medical expenses, debts, taxes, or living costs.
• Fixed and affordable premiums: Life insurance premiums are generally fixed and predictable, making it easier for the business or the partners to budget for them. The premiums are also usually affordable compared to the potential cost of the buyout, especially if the partners are young and healthy when they buy the policies. The premiums may vary depending on the type and amount of the policies, the age and health of the insured persons, and other factors.
• Protection of business value and continuity: Life insurance can help protect the value and continuity of the business by providing a smooth and orderly transfer of ownership when a partner becomes disabled. This can prevent any loss of customers, employees, suppliers, or creditors that could result from a sudden or forced sale of the business or a part of it. It can also preserve the goodwill and reputation of the company in the market.
• Peace of mind for the partners and their families: Life insurance can give peace of mind to the partners and their families by ensuring that they will receive a fair price for their share of the business and that they will not have to deal with any financial or legal problems related to the buyout. It can also reduce any potential conflicts or disagreements among the partners or their heirs regarding the value or disposition of the business.

How to Set Up and Fund a Disability Buy-Out Agreement with Life Insurance

Setting up and funding a disability buy-out agreement with life insurance involves several steps that require careful planning and professional guidance. Some of the steps are:

• Determining the value of the business and each partner’s share: The first step is to determine how much the business is worth and how much each partner’s share is worth. This can be done by using various valuation methods, such as market value, book value, discounted cash flow, or capitalization of earnings. The valuation should be based on objective and realistic criteria and should be updated regularly to reflect any changes in the business or the market. The valuation should also be agreed upon by all the partners and documented in the disability buy-out agreement.
• Drafting and signing the disability buy-out agreement with the help of legal and financial advisors: The next step is to draft and sign the disability buy-out agreement with the help of legal and financial advisors who are experienced in this area. The disability buy-out agreement should include all the essential terms and conditions of the buyout, such as the definition of disability, the price and terms of payment, the valuation method, the rights and obligations of the parties, and any other relevant clauses. The disability buy-out agreement should also be consistent with the partners’ estate planning goals and objectives.
• Choosing the type and amount of life insurance policies that suit the business needs and budget: The third step is to choose the type and amount of life insurance policies that suit the business needs and budget. There are different types of life insurance policies that can be used to fund a disability buy-out agreement, such as term life, whole life, universal life, or variable life. Each type has its own advantages and disadvantages depending on factors such as cost, coverage, cash value, flexibility, and tax implications. The amount of life insurance needed should be equal to or greater than the value of each partner’s share in the business. The amount should also be reviewed periodically to ensure that it matches the current value of the business.
• Designating the remaining partners or the business as the owner and beneficiary of the policies on each partner’s life: The fourth step is to designate the remaining partners or the business as the owner and beneficiary of the policies on each partner’s life. This means that they will pay for the premiums and will receive the disability benefits when a partner becomes disabled. They should also have an insurable interest in each partner’s life, which means that they would suffer a financial loss if a partner becomes disabled. They should also obtain written consent from each partner before buying a policy on their life.
• Reviewing and updating the disability buy-out agreement and the policies periodically: The final step is to review and update the disability buy-out agreement and the policies periodically to ensure that they reflect any changes in the business or the partners’ circumstances. For example, if the value of the business increases or decreases significantly, if a partner wants to sell or transfer their interest during their lifetime, if a partner gets married or divorced, or if there are any changes in tax laws or regulations that affect the disability buy-out agreement or the policies.

Conclusion

A disability buy-out agreement funded by life insurance is a smart way for business partners to plan for the future of their company and their family. It can provide a clear and fair mechanism for the buyout of a disabled partner’s interest and ensure that there is enough money to complete the transaction. It can also protect the value and continuity of the business and give peace of mind to the partners and their families. If you are interested in setting up a disability buy-out agreement funded by life insurance for your business, please contact us today. We can help you with the valuation, drafting, and funding of your disability buy-out agreement and provide you with expert advice and guidance along the way.