If you were to suffer a severe injury or develop some type of long-term illness, you would probably be unable to earn a paycheck during that time. Disability income insurance is a salary-continuation agreement that replaces a portion of your income while you are injured or ill. Disability insurance with your buy-sell agreement provides the funds to allow your company to continue paying your salary or to completely buy your share of the business if your disability is permanent.

Keep in mind that disability insurance is designed to protect you in the event of a long-term illness or injury. So, a disability insurance policy includes an elimination period (i.e., a waiting period between the time you become sick or injured and the time any benefits are paid). Some policies call for waiting periods as long as one or two years, so you will need to depend on your savings and other investments for a considerable period of time. Depending on the type of policy, you can receive benefit payments in either a lump sum, installment payments, or a combination of the two. Disability insurance should generally be used in addition to the funding method you have chosen for the purchase of your business interest at your death or retirement.

You should make sure that any conflict between the provisions of your disability income insurance policy and your buy-sell agreement is eliminated at the outset. The buy-sell agreement should contain the same definition of disability as your disability policy. Determine when the agreement requires a complete buyout after you become sick or injured. Also, coordinate the waiting period, how benefits are paid, and how you may be able to buy your shares back if you recover from your illness or injury.

If your buy-sell agreement is an entity purchase (stock redemption) plan, the company itself buys disability policies for each of the shareholders or partners. The company is the owner, premium payer, and beneficiary of the policies. With a cross purchase (crisscross) agreement, you and your co-owners agree as individuals to purchase the business interest of any co-owner who becomes disabled. Under the terms of the agreement, you buy a separate disability policy on each of the other co-owners; in turn, each co-owner buys a policy on you. Each of you is the owner, premium payer, and beneficiary of the policies you have purchased. Be aware that tax consequences may arise if the company pays the premiums on policies under a cross purchase agreement. A wait and see (hybrid) buy-sell agreement allows you to combine features of both an entity purchase and cross purchase agreement.

The greatest advantage offered by using disability insurance with your buy-sell agreement is that you can receive the full value of your business interest if you become disabled before your death or normal retirement. For example, say you become permanently disabled in an auto accident. You are unable to work and want to sell your interest in the business you helped establish, but the company doesn't have the cash to pay you right now. Without disability coverage in this circumstance, you might be forced to go outside the company to sell your business interest. You could end up selling the interest for less than it is worth.

Funding your buy-sell agreement with disability insurance assures that the other co-owners will buy your interest, names the conditions under which they will purchase your interest, and provides the money to pay you a fair price. If your injury is not permanent, disability insurance will provide income protection for your family while you are recovering.

• Insurance premiums are not tax deductible. It makes no difference if the payments are made by the business itself or the individual owners.
• Insurance companies may consider you uninsurable--ineligible for disability insurance--due to factors such as your age, health problems, high-risk hobbies, or employment in certain occupations.
• Disability insurance can be used only if you're sick or injured. There is no policy benefit available if you die or retire from the business when you're healthy.

It's possible that you could recover from your illness or injury after you've already sold your business interest under your buy-sell agreement's disability clause. If this happens, you could find yourself without a business, career, or income. Make sure that your buy-sell agreement addresses whether you'll be eligible to buy your shares back if you recover after the waiting period. The agreement should contain a schedule specifying how your interest will be transferred back to you. Because it is possible that you'll recover from your disability, it is generally advisable to set up a long waiting period before the policy pays salary continuation benefits or triggers the purchase of your share of the company. This reduces the chance that you may recover from your disability after having sold your business interest. In addition, longer waiting periods reduce the policy premiums.

Remember that the disability insurance with your buy-sell agreement will provide you with no benefit if the policy is allowed to lapse. Make sure that all required premiums are regularly paid. You don't want to leave yourself and your family unprotected at a time when you're sick or injured. While you're at it, check up on the other funding components of your buy-sell agreement. And if the agreement is not fully funded, push to have this done as soon as it is financially feasible for the company. Finally, as the company grows, it's important to periodically review the buy-sell document and the funding vehicles to ensure that they're keeping pace with the current value of your business.

When using life insurance with a buy-sell agreement, either the company or the individual co-owners buy life insurance policies on the lives of each co-owner (but not on themselves). If you were to die, the policyowners (the company or co-owners) receive the death benefits from the policies on your life. That money is paid to your surviving family members as payment for your interest in the business. If all goes well, your family gets a sum of cash they can use to help sustain them after your death, and the company has ensured its continuity.

• Life insurance creates a lump sum of cash to fund the buy-sell agreement at death
• Life insurance proceeds are usually paid quickly after your death, ensuring that the buy-sell transaction can be settled quickly
• Life insurance proceeds are generally income tax free; a C corporation may be subject to the alternative minimum tax (AMT)
• If sufficient cash values have built up within the policies, the funds can be accessed to purchase your business interest following your retirement or disability

• Life insurance premiums are paid with after-tax dollars because the premiums are generally not a tax-deductible expense
• Premium requirements are an ongoing expense
• One or more co-owners may be uninsurable due to age or illness
• If the co-owners' ages vary widely, younger co-owners will have to pay higher premiums on the lives of the older co-owners
• If the ownership percentages vary widely, more insurance will be needed to cover the owners with the larger ownership interests, resulting in higher premium costs for those with smaller ownership interests

In an entity purchase buy-sell agreement, the business itself buys separate life insurance policies on the lives of each of the co-owners. The business usually pays the annual premiums and is the owner and beneficiary of the policies.

In a cross purchase buy-sell agreement, each co-owner buys a life insurance policy on each of the other co-owners. Each co-owner usually pays the annual premiums on the policies they own and are the beneficiaries of the policies. If your company has a large number of co-owners, multiple policies must be purchased by each co-owner.

A wait and see (or hybrid) buy-sell agreement allows you to combine features from both the entity purchase and cross purchase models. The business can buy policies on each co-owner, the individual co-owners can buy policies on each other, or a mixture of both methods can be used.

The amount of insurance coverage on your life should equal the value of your ownership interest. Then, when you die, there will be enough cash from the policy proceeds to pay your family or estate in full for your share of the business. But if all that is affordable is insurance coverage for a portion of your interest, you might want to go ahead and fund that amount. Later, the company may be able to increase the amount of insurance or use additional funding methods. In the meantime, the agreement should specify how your family or estate will be paid.

What if the insurance proceeds turn out to be less than the value of your business interest, due to growth in the business? Your surviving family members might end up getting less than full value for your business interest. Your buy-sell agreement should specify how the valuation difference will be handled.

Conversely, the insurance proceeds might be greater than the value of your business interest when you die. Your buy-sell agreement should address this potential situation upfront and specify whether the excess funds will belong to the business, the surviving co-owners, or your family or estate.

Using a company's group life insurance plan to fund a buy-sell agreement is generally not recommended. Normally, group life insurance premiums are tax deductible to the company. But premiums are no longer deductible if the business is the beneficiary.

• For policies issued after August 16, 2006, the death benefits of life insurance on the life of an employee payable to the employer/policy owner may be subject to income taxes unless an exception applies.
• Assume your business is a corporation or is taxed as one. When one of your co-owners dies, his or her estate becomes the owner of the insurance policies covering you and the other co-owners of the business in a cross purchase agreement. If these policies are then transferred to the surviving co-owners to pay for future buyouts, a transfer-for-value (gain) may occur, and a portion of the proceeds received from the transferred policies may be taxable.
• If a policy is canceled (surrendered) for cash to buy out your interest while you are living, any gain on the policy is subject to federal income tax for the policyowner. Gain includes all policy loans outstanding at the time of surrender. Also, the policy may carry surrender charges.
• The proceeds received by a C corporation under an entity purchase agreement may be subject to the AMT.

Each year, the premiums on the policies must be paid, or the insurance will lapse. So monitor premium payments carefully. Your buy-sell agreement should include a feature requiring ongoing proof of payment. Also, review the amount of insurance regularly. The insurance coverage may have to be increased periodically to reflect increases in the value of the business. If additional insurance is not possible, another funding method should be established. Finally, periodically check the financial rating of your insurance company. The policies funding your buy-sell agreement will do your family no good if the insurer becomes insolvent.