How to Insure Your Income: Buy-Sell Agreements
The effect of a permanent disability or a disability of several years duration can be financially devastating for the family of the disabled person. If this person is the owner of a business, the financial loss can affect far more people.
The risks are even more complex when the ownership structure is a partnership or a corporation with several key stockholders.
The chance of a disability striking one of several individuals during a 20-year business relationship is high. The following chart illustrates the risk.
The Probability of a Long-Term Disability Occurring Within a Small Group
| Age | Number of People in the Group | ||||
| 2 | 3 | 4 | 5 | 6 | |
| 25 | 82.2% | 92.5% | 96.8% | 98.7% | 99.4% |
| 35 | 75.1% | 87.6% | 93.8% | 97.0% | 98.5% |
| 45 | 63.6% | 78.0% | 86.7% | 92.0% | 95.2% |
| 55 | 43.2% | 57.2% | 67.7% | 75.7% | 81.7% |
Source: 1985 CIDA Table and the 1980 CSO Table
Buy-sell agreements are common enough in closely held businesses -- but they are usually built around the death of an owner. However, they can be built around the disability of an owner.
Example: Pam and Debbie operate a preschool nursery program as a partnership. Pam is severely injured in an auto accident and is totally disabled. The prognosis is that her disability probably will last several years, and that she will never fully recover from her injury.
Debbie now has to work twice as hard to keep the business on its feet. At the same time, Pam needs her income to continue. How long can Debbie continue to work twice as hard and provide an income to her non-productive partner? Even if the partners decide to hire and train a replacement for Pam, there are problems -- where will Debbie find the time and money needed to accomplish this task?
Without disability income insurance to cover Pam, the partnership seems to be doomed to fail, and Debbie may be forced to assume the role of a liquidating trustee.
A disability buy-sell agreement is usually part of a death agreement. Most of the provisions applicable in the event of death also apply in the event of disability. The main difference is a matter of timing.
In the typical buy-sell deal triggered by the death of an owner, the process is designed to be completed within a few weeks of the death. Funds become avail-able -- from a life insurance policy -- for the purchase of the deceased's interest. The terms of the deal have been set in advance. The deal closes, and the other owners move on.
When an owner becomes disabled, other issues complicate the proceedings. The disabled owner may not want to sell. Partners or managers may not want to see the disabled owner leave. Sometimes, an owner's family members get involved in the situation -- promoting their own agendas.
A disability buy-sell agreement should contain provisions which state that, in the event of a disability, the parties involved will be bound by the agree-ment -- and the buyout will be triggered after a reasonable length of time has elapsed.
Depending on the disability, you may or may not have the opportunity to recover fully. Recovery might occur within a matter of weeks or months -- or possibly years. Or the length of the disability simply may remain unknown. A disability buy-sell provision will have to allow for this uncertainty.
For these reasons, one of the critical considerations with reference to a disability buy-sell agreement is the elimination period of the coverage that will fund the buyout. Once the elimination period is satisfied, benefits will begin to be made to the business for the purpose of buying out the interest of the disabled owner or partner.
In most cases, once the buyout begins, it cannot be stopped. So, if a disabled partner does not want to be bought out too soon, the agreement should include a long elimination period. (This has the added advantage of making the funding insurance policy cheaper.)
It's common for disability income insurance linked to a buy-sell agreement to have an elimination period of one or two years. This gives a disabled owner a chance to recover -- and protects his or her business interests from too-quick liquidation.
