Business uses of health insurance: key person, overhead…

Why a business buys disability insurance

Disability income insurance usually protects one person's paycheck. A business faces a different set of risks when an owner or a vital employee becomes disabled: revenue can fall while the bills keep coming, and co-owners may be left in business with someone who can no longer work. Three policies answer those risks: key person disability, business overhead expense (BOE) and disability buy-out (DBO). For each one, know who owns the policy, who pays the premium, who receives the benefit, what the benefit is used for, and how it is taxed.

A chart in two columns comparing three business uses of disability insurance. The left column, in green, is labeled premiums not deductible, benefits tax-free. It holds two boxes. The first is key person disability: the business owns the policy and is the beneficiary, and the benefit pays for lost profits and for finding and training a replacement. The second is disability buy-out: it funds a buy-sell agreement, has a long elimination period of twelve to twenty-four months, and pays as a lump sum or in installments. The right column, in red, is labeled premiums deductible, benefits taxable. It holds one box, business overhead expense, which reimburses actual overhead such as rent, utilities, staff salaries and leases, does not pay the owner's own salary or profit, has a short elimination period and a benefit period usually of twelve to twenty-four months. A note says the taxable benefits pay deductible expenses, so the tax nets out. — Key person and buy-out: after-tax premiums, tax-free benefits. Overhead expense: deductible premiums, taxable benefits.

Key person disability

Purpose: protects the business against the loss of revenue and the cost of replacing an employee whose skills, contacts or knowledge drive profits.
Owner, payor and beneficiary: the business. The key person is only the insured.
Uses of the benefit: offsets lost profits, and pays to recruit, hire and train a replacement or bring in temporary help.
Tax treatment: premiums are not deductible as a business expense, and benefits are received income-tax free by the business.

Business overhead expense (BOE)

Purpose: keeps the doors open while a disabled owner recovers. It is sold to sole proprietors, partners and professionals in small practices, such as physicians, dentists and accountants.
Covered expenses: the normal, ongoing costs of running the business, such as rent or mortgage payments on the business premises, utilities, telephone, salaries of employees other than the owner, equipment leases, insurance premiums and professional dues.
Not covered: the disabled owner's own salary or profits, which belong in a personal disability income policy, and the cost of inventory or goods held for sale.
Benefit design: a reimbursement contract. It pays the overhead actually incurred, up to the monthly maximum. It typically has a short elimination period (often 15 to 30 days) and a short benefit period, usually 12 to 24 months, because the coverage is meant to bridge a recovery or an orderly sale, not to run for decades.
Tax treatment: premiums are deductible as an ordinary business expense, so the benefits are taxable income to the business. Because the benefits pay expenses that are themselves deductible, the net tax effect is usually neutral.

Disability buy-out (DBO)

Purpose: funds a buy-sell agreement so the healthy owners can buy the disabled owner's share of the business. The disabled owner gets fair value for the interest, and the business continues without a partner who cannot contribute.
Owner and beneficiary: the business itself (an entity, or stock redemption, plan) or each co-owner on the others (a cross-purchase plan).
Benefit design: a long elimination period, commonly 12 months and sometimes up to 24, so that a short disability does not trigger a permanent sale. Benefits may be paid as a lump sum, in installments or as a down payment followed by installments. Insurers generally require a written buy-sell agreement and a business valuation.
Tax treatment: premiums are not deductible, and benefits are received income-tax free.

The tax rule underneath it all

The pattern follows one principle: when premiums are deducted, benefits are taxed; when premiums are paid with after-tax dollars, benefits are tax-free. For individuals the federal statutes state it directly. Benefits from accident or health insurance are excluded from gross income under 26 U.S.C. § 104(a)(3), except to the extent they come from employer contributions the employee was not taxed on, or are paid by the employer. Section 105(a) then pulls those employer-funded benefits back into the employee's income. Section 106(a) lets the employee exclude the employer-paid coverage itself. So in a group disability plan where the employer pays the premium, the premium is tax-free to the employee but the disability checks are taxable. If the employee pays the premium with after-tax dollars, the checks are tax-free.

Exam tip: BOE is the one business disability policy with deductible premiums and taxable benefits. Key person and disability buy-out are the reverse: non-deductible premiums, tax-free benefits.

Business uses of health insurance: key person, overhead expense, and disability buy-out