Buy-Sell Insurance: Disability Funding

Executive Summary

When a business partner becomes disabled and can't return to work, their shares may need to be transferred. A buy-sell agreement can define how this happens, but it needs funding. In Canada, disability insurance is commonly used to fund buy-sell agreements. Here's what matters:

• The problem: Without funding, surviving partners may not have cash to buy out a disabled partner's shares, and the disabled partner may need liquidity
• The solution: Disability insurance provides guaranteed liquidity when disability benefits become payable
• The complexity: Disability is harder to define than death:it requires clear definitions and adjudication processes
• The tax difference: Unlike life insurance, disability insurance proceeds do not create a Capital Dividend Account (CDA) credit, affecting how buy-outs are structured
• The flexibility: Payment can be structured as lump sum, installments, or a combination, depending on your needs

This article explains how disability insurance funds buy-sell agreements and what to consider when structuring the funding.

Mindset: Planning for the Unexpected

Before diving into the technical details, let's think about disability buy-sell funding from a long-term perspective.

Disability is different from death. Death is certain and final. Disability can be temporary or permanent, partial or total, and may improve or worsen over time. This creates complexity in planning.

When a partner becomes disabled:

1. The business needs to continue under the remaining partners' control
2. The disabled partner may need liquidity but may also want to maintain some connection to the business
3. The remaining partners need clarity about control and decision-making

Without a funded buy-sell agreement, uncertainty can affect:

• Business operations and decision-making
• The disabled partner's financial situation
• Relationships between partners
• The ability to move forward with business plans

Disability insurance solves this by providing cash when disability benefits become payable. The insurance proceeds fund the share purchase, ensuring:

• The remaining partners gain control when appropriate
• The disabled partner receives fair value
• The business can continue without ongoing uncertainty

This is about protecting what you've built while providing flexibility for different outcomes.

Mechanics: How Disability Insurance Funds Buy-Sell Agreements

A buy-sell agreement can define what happens when a partner becomes disabled. It specifies:

• When disability triggers a buy-out (definition and elimination period)
• Who buys the shares (remaining partners or the corporation)
• How the price is determined
• How payment is made

Disability insurance provides the cash to make this happen. Here's how it works:

The Basic Structure

1. Insurance is purchased on each partner, with a benefit amount equal to their share value
2. The policy defines disability and includes an elimination period
3. Premiums are paid regularly to keep the policies in force
4. When a partner becomes disabled and the elimination period is satisfied, benefits become payable
5. The proceeds fund the purchase of the disabled partner's shares

The Key Difference from Life Insurance

Unlike life insurance death benefits:

• Disability insurance proceeds do not create a CDA credit
• This means the proceeds cannot be distributed as tax-free capital dividends
• The tax treatment depends on how the buy-out is structured (capital gains vs. dividend treatment)

This affects which funding methods work best for disability buy-sell agreements.

Disability Definitions and Adjudication

One of the most important aspects of disability buy-sell funding is defining what "disabled" means and who decides when that definition is met.

Defining Disability

Disability buy-out insurance typically requires:

• Total disability (unable to perform the duties of your occupation)
• Permanent disability (not expected to recover)
• Prolonged or long-term disability (lasting beyond a certain period)

The definition matters because it determines when benefits become payable and when a buy-out can occur.

Elimination Period

The elimination period is the time during which a partner must be disabled before benefits become payable. Common elimination periods are:

• 12 months
• 18 months
• 24 months
• 36 months

Longer elimination periods can:

• Allow for higher benefit amounts
• Reduce premium costs
• Give more time to determine if disability is permanent

The elimination period should align with how long partners want to wait before triggering a buy-out.

Adjudication: Who Decides?

When disability insurance funds the buy-sell agreement:

• The insurance company adjudicates whether disability exists
• The policy definition determines when benefits become payable
• The buy-sell agreement links the triggering event to when insurance benefits become payable

This "outsources" the disability determination to an impartial third party (the insurer), which can reduce disputes between partners.

Without Insurance Funding

If disability buy-out insurance is not in place:

• The buy-sell agreement must define disability itself
• The agreement must include an adjudication process
• Partners must agree on when disability exists (which can be contentious)

This is why disability insurance funding is often preferred:it provides an objective determination.

Funding Methods: Structuring Disability Buy-Sell Funding

There are two main methods for structuring disability buy-sell funding. The tax treatment differs from death buy-sell funding because disability proceeds don't create CDA credits.

Method 1: Criss-Cross Purchase Method

How it works:

• Partners own disability insurance on each other (or through holding companies)
• When a partner becomes disabled, the remaining partners receive insurance proceeds
• The remaining partners use the proceeds to purchase the disabled partner's shares

Tax treatment:

• The disabled partner receives capital gains treatment on the sale
• This allows the disabled partner to claim the capital gains exemption if available
• The remaining partners' adjusted cost base increases based on what they paid

Payment structure:

• Proceeds can be received as lump sum or installments
• If installments, the remaining partners purchase shares with a promissory note
• Insurance proceeds repay the promissory note over time

When it works well:

• When you want capital gains treatment for the disabled partner
• When there are only two partners
• When you want to avoid corporate creditor issues

Method 2: Corporate Redemption Method

How it works:

• The corporation owns disability insurance on each partner
• When a partner becomes disabled, the corporation receives insurance proceeds
• The corporation uses the proceeds to redeem the disabled partner's shares

Tax treatment:

• The disabled partner receives dividend treatment (not capital gains)
• This may limit the ability to claim the capital gains exemption
• The remaining partners' adjusted cost base increases

Payment structure:

• Proceeds can be received as lump sum or installments
• If installments, the corporation redeems shares over time as proceeds are received
• Alternatively, shares can be frozen at the triggering event and redeemed over time

When it works well:

• When you want simpler administration (one policy per partner)
• When the corporation can manage installment payments
• When dividend treatment is acceptable

Disability Insurance Product Features

Disability buy-out insurance has specific features that differ from life insurance:

Issue Limits

Disability buy-out insurance may have lower issue limits than life insurance. This means:

• You may not be able to insure the full business value
• Coverage may not keep pace with business growth
• The buy-sell agreement should address how to handle unfunded portions

Strategies to address limits:

• Use longer elimination periods (can allow higher benefit amounts)
• Use installment payment methods (can enable higher total benefits)
• Combine with other funding sources for the unfunded portion

Payment Methods

Disability buy-out insurance can be paid as:

• Lump sum: Full amount paid when benefits become payable
• Installments: Monthly payments over a period (e.g., 5-10 years)
• Combination: Lump sum plus installments

Considerations:

• Lump sum provides immediate full buy-out
• Installments provide ongoing payments but cease on death
• The buy-sell agreement should address what happens if payments cease

Underwriting Requirements

Disability buy-out insurance requires:

• Financial underwriting: Business financial statements and valuations to validate coverage amounts
• Medical underwriting: Health assessments for each partner
• Proof of value at claim: The business value must be proven when a claim is made

Proceeds are limited to the lesser of:

• The coverage amount in force
• The fair market value of the business at the time of claim

Insurability Issues

Not all partners may be insurable. The buy-sell agreement should address:

• What happens if one partner cannot be insured
• Alternative funding methods for uninsurable partners
• How to handle partial coverage

Cost Considerations

Disability buy-out insurance premiums depend on:

• Age and health of each partner
• Occupation risk category
• Benefit amount
• Elimination period
• Payment method

Example: A 45-year-old male, non-smoker, in the best occupation category, with $500,000 coverage and a 12-month elimination period might pay approximately $3,245 annually for lump sum coverage.

Probability considerations:

• The probability of disability lasting at least 12 months before age 63 is approximately 7% for one individual
• With three partners, the probability that one will suffer such a disability increases to roughly 20%

After-tax cost:

• Premiums are not deductible
• Consider whether corporate-owned or personally-owned insurance is more cost-effective after tax
• This may influence which funding method you choose

How to Apply: Steps for Structuring Disability Buy-Sell Funding

If you're considering disability buy-sell funding with insurance, here's how to approach it:

Step 1: Establish the Buy-Sell Agreement

Work with your lawyer to create or update your shareholders' agreement. The agreement should:

• Define disability (or link to insurance policy definitions)
• Specify elimination period requirements
• Define who buys the shares and how payment is made
• Include insurance provisions
• Address what happens if insurance is insufficient or unavailable

Step 2: Determine the Funding Method

Work with your CPA and insurance advisor to choose the right method:

• Consider tax implications (capital gains vs. dividend treatment)
• Consider payment structure (lump sum vs. installments)
• Consider corporate structure (individual shareholders vs. holding companies)
• Consider creditor protection needs

Step 3: Value the Business

Determine fair market value for buy-sell purposes:

• Use a formula (e.g., book value, multiple of earnings)
• Use annual valuations
• Use an independent business valuator
• The insurance coverage should match this value (subject to issue limits)

Step 4: Structure the Insurance

Work with your insurance advisor to:

• Determine coverage amounts for each partner (subject to issue limits)
• Choose elimination period (12-36 months)
• Choose payment method (lump sum, installments, or combination)
• Choose policy ownership (corporate vs. personal)
• Set up premium payment mechanisms
• Address insurability issues

Step 5: Address Unfunded Portions

If insurance doesn't cover the full business value:

• Define how the unfunded portion will be paid
• Consider payment terms (promissory note, installments)
• Consider timing of payments

Step 6: Coordinate with Your Professional Team

Ensure your lawyer, CPA, and insurance advisor coordinate:

• The agreement matches the insurance structure
• Disability definitions are consistent
• Tax elections are made correctly
• Premium payments are monitored
• The structure is reviewed regularly

Worked Example: Criss-Cross Purchase with Installments

Let's say two partners (A and B) each own 50% of a corporation worth $1 million. Each partner's shares are worth $500,000.

Setup:

• Each partner owns $500,000 of disability buy-out insurance on the other partner
• Elimination period: 18 months
• Payment method: Monthly installments over 5 years ($8,333 per month)
• The buy-sell agreement requires remaining partner to purchase shares when disability benefits become payable

When Partner B becomes disabled:

1. Partner B is disabled for 18 months
2. Disability insurance benefits become payable to Partner A
3. Partner A begins receiving $8,333 per month for 5 years
4. Partner A purchases Partner B's shares using a promissory note
5. Partner A uses insurance proceeds to repay the promissory note over 5 years
6. Partner B receives capital gains treatment on the sale
7. Partner A now owns 100% of the corporation

Result:

• Partner B receives fair value with capital gains treatment
• Partner A gains control and repays over time using insurance proceeds
• The business continues without ongoing uncertainty

Decision Checklist

This approach might be right for your partnership if:

• [ ] You have business partners (two or more owners)
• [ ] There's no disability buy-sell provision, or the existing provision lacks funding
• [ ] One partner's disability would create uncertainty about share transfer and business control
• [ ] The business has significant value that needs protection
• [ ] You want to ensure fair value transfer while protecting business operations
• [ ] You want guaranteed liquidity (insurance) rather than relying on business cash flow or borrowing
• [ ] You're comfortable with an elimination period (12-36 months) before buy-out occurs

If several of these apply, consider discussing your situation with your lawyer, CPA, and insurance advisor to explore whether a funded disability buy-sell agreement makes sense for your partnership.

Important Notes

This is educational information. Buy-sell agreements are legal documents that should be prepared by lawyers familiar with business law and partnership structures. Disability insurance funding requires coordination with insurance advisors, and tax implications should be reviewed with your CPA. Always consult with your professional team.

Every situation is unique. Funding methods, insurance structures, and agreement terms depend on many factors including business type, corporate structure, partner relationships, and legal considerations. What works in one case may not be appropriate for your circumstances.

Disability definitions matter. Disability buy-sell funding relies on clear definitions and adjudication processes. Working with disability insurance can provide objective determination, but the definitions and elimination periods must align with your partnership's needs.

Insurance is offered through iAssure Inc. Insurance products and related services are provided through iAssure Inc., an independent firm in the insurance of persons and in the group insurance of persons. These activities are neither the business nor the responsibility of WhiteHaven Securities Inc.

Next Steps

If this approach resonates with your situation:

• Assess your current situation: Do you have disability buy-sell provisions? Are they funded? When was it last reviewed?
• Understand your business value: Work with your CPA and potentially a business valuator to understand how your business might be valued
• Consider disability definitions: Think about what "disabled" should mean for your partnership and how long an elimination period makes sense
• Coordinate with your team: Discuss disability buy-sell agreements with your lawyer, CPA, and insurance advisor to ensure all aspects align
• Consider funding options: Explore how disability insurance might fund your buy-sell agreement and provide guaranteed liquidity

If you'd like to discuss your specific situation, request a structure review to see if there's a fit.