In early 1990, a group of 6 orthopedic surgeons formed a partnership. In an effort to secure financial protection for the company, they hired an attorney to draft a contract. One section of the contract required the surgeons to buy out a partner if one of the partners became disabled.
A year ago, one of the 6 was in an accident that required him to stop working. The other partners turned to the contract requirements in order to buy out the disabled partner but quickly realized that a mechanism to fund the buy-out did not exist.
It was at this time that they decided to consult a financial representative, who suggested a disability buy-out (DBO) policy to fund their buy-sell agreement.
A buy-sell agreement is a legally binding, mutual agreement among business partners that establishes a buy-out price at the formation of the partnership that is fair to both the disabled associate and the remaining owner(s). A DBO policy can help business owners, particularly small business owners, who find themselves in a variety of situations such as:
o One partner becomes disabled and cannot actively contribute to the business but continues to collect a salary. Eventually, the other partner(s) hires a replacement to take on the disabled partner’s responsibilities. Consequently, there is a dual cash drain on the business.
o A disabled partner becomes more financially conservative in order to protect his/her investment. As a result, growth opportunities are missed and resentment and conflicts arise among the partners.
o The disabled partner is unable to pay his/her medical bills or maintain the previous standard of living and decides to seek a quick sale. The other partner(s) could be forced to sell at a discount, or may not be involved in selecting the buyer, which could lead to a bad fit for the company.
In each situation, a DBO policy would fund a business’s buy-out agreement and pay benefits to the healthy partner(s). It reimburses the money spent on purchasing the business interest of the disabled owner.
Few small businesses develop buy-sell agreements at the formation of a company. Those that do implement such an agreement rarely outline the funding requirements of such a provision. In addition, many business owners completely disregard disability as a possibility when, in fact, it is quite common.
Most people believe they have a minimal chance of becoming disabled in their working years. However, the actual facts are startling. (See box.)
Financial representatives should reveal these facts to their small business owner clients, demonstrating the need for disability insurance. The next step would be to suggest a DBO policy, which would help fill a large gap in a company’s financial planning and protect the partners in the event that a disability begins to affect the business.
How does a DBO work? Here are 3 examples:
Entity Purchase DBO. In this type of agreement, the business acts as the applicant, owner and payer on the insurance policy covering each partner. The buy-out would go into effect upon the corporation’s purchase of the disabled partner’s business interest. Income from the policy would reimburse the corporation for this purchase.
Cross Purchase DBO. This type of agreement is best for companies with no more than 3 partners. In a cross purchase buy-out, each partner purchases a DBO policy on the lives of the other partners, making each partner a policy owner, beneficiary and premium payer on the policy.
Cross Purchase DBO with Trustee. A “trusted” cross purchase buy-out is used when a company has more than 3 partners, all of whom wish to retain the tax advantage of a stepped-up basis should they decide to sell their interest. This agreement also offers the advantage of limiting the number of policies to the number of owners, simplifying the administration of the plan.
With every DBO policy, there are taxation issues to consider. Regardless of the type of business, premiums paid for a DBO policy are not tax deductible to the owner or the business; however, benefits are paid on an income tax-free basis. Keep in mind that there may be a capital gains tax due if the payment to the disabled owner exceeds the initial cost basis in the business.
Many small business owners are not well informed when it comes to financial planning, and few are aware of the high probability that a disability could negatively affect their business. Consequently, they do not consider DBO policies and often skip over disability insurance completely.
This is an opportunity for financial representatives to provide clients with a much-needed product that could potentially protect their businesses from financial ruin. As soon as a relationship between a financial representative and a small business owner begins, a DBO policy should be proposed as part of the financial planning process.
Howard Udoff is a financial representative and disability supervisor at International Planning Alliance, LLC, Fairfield, N.J., an agency affiliated with Guardian Life Insurance Company of America. His e-mail is HUdoff@planningalliance.com.