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).

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.

About 25 years ago, I started working with a veterinary practice that we’ll call MW Vet. One of the founders, Doc, owned 50% of the practice, while Doc’s son and a third veterinarian each had a 25% interest. A buy-sell agreement and universal life policies were in place when I met them. The funding of those policies was increased, particularly the one on Doc, to provide supplemental retirement income. In addition, a disability salary continuation plan and disability buyout insurance policies were put into place.

Ten years later, Doc sold his portion of the practice to 2 new veterinarians and the cash value of his universal life policy was used to provide supplementary retirement income. The result was that 4 veterinarians owned the practice, each with a 25% ownership interest. The business was changed from a C corporation to an S corporation. After consulting with the firm’s CPA, it was decided to use an entity purchase agreement funded with universal life and disability buyout policies.

About 5 years ago, one of the veterinarians, Bob, was lifting weights at the YMCA and felt a pain in his back. He was diagnosed with inoperable spinal cancer and given 6 months to live, but lived for almost 2 1/2 years. He started collecting disability income benefits after 90 days. At the end of 12 months, a lump sum down payment from his disability buyout policy was paid, followed by monthly installments scheduled over 60 months.

The monthly income from the buyout was enough to let Bob’s wife quit work to stay at home with him for the last 16 months of his life. When Bob died in the 28th month of his disability, the monthly disability buyout payments stopped, but the life policy death benefit was paid, allowing MW Vet to complete the buyout.

Because some disability buyout payments had been received, there was excess cash available from the life insurance after the buyout was completed. MW Vet made the decision to pay that death benefit to Bob’s widow.

Two years later, this practice is prospering and is in the process of allowing 2 younger veterinarians to buy into the practice, assuring that the business will continue into the next generation. This is an example of one practice that has successfully bought out one owner at retirement and another who became disabled and then died. Imagine what would have happened if all the possible contingencies hadn’t been covered in their buy-sell agreement.

I encourage you to review the buy-sell agreements of your business clients and prospects. Make sure that death, disability, disagreement, and, where appropriate, retirement are covered and properly funded.