Many closely held businesses have buy-sell agreements in place. However, many of these agreements fall short of adequately covering one or more of the “three Ds”: death, disability and disagreement.
In general, advisors have done a good job of explaining the need for a buy-sell agreement covering the death of an owner and the need for life insurance to fund that agreement, as evidenced by the many businesses that have life insurance-funded buy-sell agreements. During the early years of a business, these agreements are often funded with term life insurance.
As a business matures, it can be advantageous to convert that term insurance to permanent insurance. This is because cash value that increases on policies owned by an S corporation or other pass-through entity helps offset premium expenses, and the death benefits increase the basis of individual shareholders.
In contrast, disability clauses in buy-sell agreements are often written poorly or may be missing altogether. Many agreements have a disability buyout trigger point of 90 days. However, because the rate of recovery is quite high during the first year of a disability, a buyout should not occur until at least 12 months of continuous disability (18 and 24 months are other options).
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Charts that show that disabilities are about 3 times more likely to occur than death are often used as justification for disability buyout insurance. However, those charts are based on 90-day disabilities. Instead, statistics that show the incidence of disabilities lasting one year should be used. The odds of a 12-month disability are just slightly higher than the odds of a death prior to age 65.
The third D, disagreement, is also often overlooked but should be included in the agreement. It is much easier for business owners to agree on buyout terms while everyone is getting along than after a disagreement has occurred.
A fourth trigger for a buyout is retirement. However, in many cases it is only when owners are near retirement and willing to give up control that planning for retirement becomes a priority.