One of the primary reasons people form partnerships and corporations is to benefit from the combined talents of multiple business owners. Once they form a business entity, it will only be successful if the major players all make important contributions to running the business.
Most business owners rarely take the time to stop and analyze the impact to their business that the absence of a major player would cause. Just imagine if suddenly one of the key players in the business could no longer come to work because of a work-ending disability.
When this happens it becomes apparent how critical each individuals contribution is on an on-going basis. This is particularly true in small businesses where any prolonged absence of a principal is felt. When the absence of a key player is a result of a disability, a whole host of issues surface:
–If it is a short-term disability of a few days or weeks, somehow the workload gets distributed among the well employees; in some cases a temp can be brought in.
–If it is a long term or permanent disability, it can open a “Pandoras box” of complicated problems for the remaining owners.
In addition to the legal issues that need to be dealt with, a long-term disability can raise moral issues among fellow business partners. For instance, individuals who work closely together in a small business establish not only a business relationship, but also many times, a personal one that may involve other family members, such as spouses. In a tightly knit group of business partners, discussions that take place with key members absent may cause a rift in the relationship.
There are a number of other conflicts that also need to be addressed (see sidebar).
What Are The Chances of This Happening?
With all the key players busy running the business, chances are this is a minor area of concern. Many times, they feel this is the sort of thing you read about in the newspaper. These owners usually have the attitude that, “It happens, but chances are good that it will not happen to anyone in our business.”
Actually, the odds are noteworthy. Consider these statistics for a multi-owner business. The chances of at least one owner becoming disabled for 90 days or more before age 65 are as follows:
–With two owners, both age 35, there is a 34% chance that one will become disabled.
–With three owners, all age 35, there is a 47% chance that one will become disabled.
–Of all 45-year-olds disabled for at least one year, after five more years:
–19.9% will have died.
–57.5% will still be disabled.
Clearly, the odds are much greater that a disability will occur instead of a death before age 65 with multi-owner businesses. Despite these staggering statistics, more businesses address the death issue while completely overlooking the disability issue. Or even worse, address both the death and disability issues, recognizing the liabilities of both, but only funding for the event of death.
The solution should take into consideration the need to recognize and fund for two emerging problems.
1. Income for the disabled owner and his or her family pursuant to a wage continuation agreement that is funded by disability insurance.
2. Income for the business to purchase the disabled owners interest pursuant to a buy/sell agreement funded with disability buy/sell insurance.
The disability income insurance is typically funded after 90 days of disability to encompass normal working years, usually considered to be age 65.
The buy/sell insurance is typically funded after 12, 18, or 24 months of disability. It becomes critical that a buyout is not triggered without adequate time to determine the prognosis and to see if the disabled owner will be able to return to work. You do not want to destroy a business relationship unnecessarily.
Ideally, the buy/sell agreement establishes a mandatory requirement for the other owner to purchase the entire interest of the disabled owner for a price agreed upon in advance, utilizing the funds from the buy/sell policy. Ownership is then transferred, with the money paid either as a lump sum, in the form of installments, or a combination of the two.
Generally speaking, a disability buy/sell agreement can be structured in one of two ways: a cross-purchase arrangement, or an entity purchase arrangement. While a detailed description of these is beyond the scope of this article, a brief explanation of each can be found in the charts on this page.
Premiums paid for a disability plan to replace the disabled partners income pursuant to a wage continuation agreement are deductible for the business as a “necessary business expense,” IRC Section 162(a). Benefits received by the disabled individual are subject to tax as ordinary income, IRC Section 105(d).
Premiums paid for disability buy/sell plans are not deductible for the business under any circumstances, IRC Section 264(a)(1). Benefits are realized on a non-taxable basis, IRC Section 104(a)(3). However, payments made to the disabled owner under the terms of the buy/sell agreement are taxed as a capital transaction.
If the buyout proceeds are realized in a lump sum, the entire gain will be taxed in the year received. Or, if the proceeds from the sale are paid on an installment basis over a number of years, any gain will be taxed over that period of years rather than in a single year. The payments each year are considered a combination of (1) return of capital, which is not taxable and (2) capital gains and interest, which are subject to tax.
Proper attention to succession planning needs to be given the same level of priority that is given to other aspects of your business. After all, the principals have invested their time, talents and money to make the business a success and to create a very valuable asset. Not to protect it in a sensible way is foolhardy.
Michael J. Eskra, CLU, RHU, is president and CEO of Eskra and Associates, Inc., Coral Gables, Fla. His brokerage operation specializes in disability, long term care, life and employee benefits. He may reached via e-mail at email@example.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, February 11, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.