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Disability insurance specialist workshop

Larry Schneider

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As a disability insurance specialist, you can increase your sales and earn higher commissions. Schneider shares how to avoid underwriting land mines, which will result in fewer declines and policies not taken. He also shares how to overcome the group LTD “reverse discrimination,” which will create more sales opportunities.

Are you satisfied with your group LTD disability coverage? Well, take a closer look.

Association/group LTD, deficiencies/shortcomings:

  1. Taxation of benefits: Taxable when premium is employer-paid, creating a situation whereby only a maximum of 40 percent of income is kept after taxes
  2. Benefit amount: Not guaranteed, can fluctuate based on income at time of claim
  3. Offsets: Benefit amount can be reduced by other sources, e.g., Social Security, workers’ compensation, etc., thus reducing the 40 percent (see No. 1 above)
  4. Portability: Certificate usually not portable
  5. Plan administration: Time consuming
  6. Option choices: May be limited (COLA/residual, etc.)
  7. Definition of “total disability” (own-occupation): May not allow benefits to be paid to 65, rather only for two years, then another definition takes over
  8. Bonus: Normally not covered, creating a coverage amount shortfall
  9. Contractual wording: Protects the carrier more than the insured
  10. Rates: Not guaranteed; can be increased unilaterally
  11. Renewability: Not guaranteed; coverage can be canceled anytime by carrier; also, coverage will terminate at 65
  12. Claims: Acts of bad faith not discouraged due to ERISA; can’t sue for punitive damages; claim can drag
  13. Claims: Can only be submitted while working and while coverage is in force
  14. Pre-existing conditions: May create an unanticipated problem at claim time
  15. Contract wording: Can be changed by carrier anytime to be less favorable to the insured
  16. Mental nervous claims: Will be paid only for two years
  17. Recovery benefit: None
  18. COLA conversion: None
  19. Presumptive disability: None
  20. Caps: High-income employees who make more than $100,000/year and who are only covered for 60 percent with a maximum of $5,000 are discriminated against

Note: Not all of the above (e.g., Nos. 5 and 7) apply to association coverage. Individual disability income coverage avoids all these problems.

Table 1: Individual vs. Association/Group Comparison
Feature Group Assoc. Indiv.
Non-can No No Yes
Guaranteed renew No No Yes
Own occupation Rarely Rarely Yes
Lifetime benefit No No Yes
Integration SS/WC Yes Yes No
Elim. period problem Yes Yes No
COLA Rarely Rarely Yes
Termination @ 65 Yes Yes No
Portable No No Yes
Pre-X cond. Excl. No No Yes
Cost Low Low High
Underwriting Maybe Maybe Yes

Is long-term disability for everyone?

Long-term disability (LTD) definitely is not for everyone, especially the highly paid executive (HPE). Just as one size doesn’t fit all, not everyone will find it to their benefit to have this form of coverage. In fact, and to the contrary, it may actually turn out to be detrimental to their financial security!

HPEs rarely realize all of the limitations of LTD, especially the dollar benefit impositions placed on income replacement. For example, those who are making $200,000 or more may wind up with a net of only 20 percent of pre-disability, pretaxed income. And it could even be less (taxes, offsets, cap). Pretty gruesome picture, isn’t it?

You’ve probably heard of the aforementioned scenario referred to as “reverse discrimination.” For those of you who are not yet familiar with this power phrase/door opener, this is a situation where middle- to lower-management executives making $100,000 or less (under a $5,000 cap) get the full percentage (usually 60) of income replacement under a typical LTD contract. On the other hand, for those making more than $100,000, reverse discrimination rears its ugly head. This income level group gets a scaled-down amount of income replaced — the more one makes, the less one will receive when there is a claim (based on percent of income). It’s one of the few times top management and/or owners are penalized, and so the term “reverse discrimination” (see Table 2).

Table 2: Long-Term Disability Reverse Discrimination Disability Plan: Maximum Benefit $5,000 Monthly 60% of Salary (Including Social Security Benefits)
  Total Monthly Benefit as Percent of Salary
Key Person Annual Salary Monthly Salary 60% of Salary Total Monthly Benefit Before Taxes After Taxes
VP $50,000 $4,166 $2,500 $2,500 60% 40%
VP 100,000 8,333 5,000 5,000 60 40
VP 120,000 10,000 6,000 5,000 50 33
VP 180,000 15,000 9,000 5,000 33 22
VP 200,000 16,666 10,00 5,000 30 20
VP 240,000 20,000 12,00 5,000 25 16
CFO 300,000 25,000 15,00 5,000 20 13
CEO 360,000 30,000 18,00 5,000 17 11

LTD should only be sold for what it is and no more — income replacement for middle- to lower-management/employees, which is where there is relative worth to both the employer and employee. The remainder of the employees (HPEs who usually make up 15 percent of the organization and receive 50 percent of its payroll) should not consider this form of coverage at all. They should not view LTD as comprehensive coverage but, instead, as coverage that could be detrimental to their financial security.

My contention is based on the following facts and how they, in particular, affect not only middle to lower management but especially the HPE:

  • Benefits are taxable (IRC 105(a)).
  • Income is not fully covered due to cap, and bonuses are usually excluded from coverage.
  • Benefits are further reduced by offsets such as Social Security, workers’ compensation, (occasionally) other individual coverage and/or retirement/pension plans.
  • Benefits are again further reduced by the fact that inflation erodes the monthly benefit of buying power — COLA usually isn’t an option (see Table 3), which illustrates the effect of inflation. You’ll note that the buying power of the $5,000 monthly benefit without COLA has been reduced to $3,833 at the end of the 10th year, a reduction of 24 percent.
  • Other LTD deficiencies (see Table 4).
Table 3: Monthly Benefit Buying Power With and Without Cost-of-Living Adjustment (COLA) and Inflation
Fixed Benefit Amount without COLA Buyer Power of Monthly Benefit at 3% Inflation Buyer Power of Monthly Benefit with 3% COLA
Year Monthly Benefit Cumulative Annual Monthly Benefit Cumulative Annual Monthly Benefit Cumulative Annual
1 $5,000 $45,000 $5,000 $45,000 $5,000 $45,000
2 5,000 105,000  4,854 103,248 5,150 106,800
3 5,000 165,000 4,713 159,804 5,305 170,460
4 5,000 225,000 4,576 214,716 5,464 236,028
5 5,000 285,000 4,443 268,032 5,628 303,564
6 5,000 345,000 4,314 319,800 5,797 373,128
7 5,000 405,000 4,188 370,056 5,971 444,780
8 5,000 465,000 4,066 418,848 6,150 518,580
9 5,000 525,000 3,948 466,224 6,335 594,600
10 5,000 585,000 3,833 512,220 6,525 672,900
11 5,000 645,000 3,721 556,872 6721 753,552
12 5,000 705,000 3,613 600,228 6,923 836,628
13 5,000 765,000 3508 642,324 7,131 922,200
14 5,000 825,000 3,406 683,196 7,345 1,010,340
15 5,000 885,000 3,307 722,880 7,565 1,101,120
16 5,000 945,000 3,211 761,412 7,792 1,194,624
17 5,000 1,005,000 3,117 798,816 8,026 1,290,936
18 5,000 1,065,000 3,026 835,128 8,267 1,390,140
19 5,000 1,125,000 2,938 870,384 8,515 1,492,320
20 5,000 1,185,000 2,852 904,608 8,770 1,597,560
21 5,000 1,245,000 2,769 937,836 9,003 1,705,956
22 5,000 1,305,000 2,688 970,092 9,304 1,817,604
23 5,000 1,365,000 2,610 1,001,412 9,583 1,932,600
24 5,000 1,425,000 2534 1,031,820 9,870 2,051,040
25 5,000 1,485,000 2,460 1,061,340 10,166 2,173,032
Table 4: Disadvantages of Employer Paid LTD Plans
Event Consequences
Event Consequences
Benefit amount Taxable
Cap Creates reverse discrimination
Offsets Reduces benefits payable
Workers’ comp Reduces benefits payable
Social Security individual DI Reduces benefits payable
Retirement/pension Reduces benefits payable
Bonus Not covered by LTD (usually)
Mental/nervous Covered 24 months only
Coverage Can be canceled at will by carrier
Rates Premium not guaranteed
Employment termination Coverage is usually not portable
Benefit period Payable only to 65, subject to ERISA
Options Usually lacking COLA, etc.
Definitions Makes claim difficult to collect (restrictive definition of total disability; “back-to-work days” makes the elimination period more difficult to satisfy)

Many fine articles have been written on how to correct the aforementioned “discrimination” problem. These usually have been referred to as an LTD combo sale. I, for one, don’t agree that this solution is the only solution or that it is always in the best interests of the HPE to have this arrangement. Again, just to make sure we are all saying the same thing, I want to explain what the solution entails. It’s a remedy whereby an additional amount of individual non-can/guaranteed renewable disability insurance is “wrapped” around the LTD to supplement the impositions of the cap and replace what taxes have taken. Remember, under an LTD plan, when the premium is paid for by the employer (IRC 162), these amounts are not included as taxable income to the employee (IRC 106), but the benefits payable are (IRC 105(a)).

This “combo” solution, as previously stated, is only a compromise, and, like most compromises, the end result is less than perfect! Table 5 illustrates how the HPE may still wind up with only 45 percent of pre-disability income under this solution!

Table 5: Long-Term Disability/Combo—$5,000/Month Cap
Annual Income Annual Max LTD Benefit % of Annual Benefit to Income Max Individual Coverage Allowed with LTD Maximum Additional Individual Annual Coverage % of Increase Over LTD Max % of Total Benefit to Income Before/After Taxes Offsets and Bonuses Exclusive
$50,000 $30,000 60% $34,200 $4,200 11% 68.4% /45.1% Unknown
100,000 60,000 60 69,000 9,000 15 69.0/45.5
120,000 60,000 50 81,000 21,000 35 67.5/44.5
180,000 60,000 33 117,600 57,600 96 65.3/42.9
200,000 60,000 30 129,600 69,600 116 64.8/42.7
240,000 60,000 24 154,200 94,200 157 64.2/42.3
300,000 60,000 20 190,800 130,800 218 63.6/41.9
360,000 60,000 17 222,000 162,000 217 61.6/40.6
        (4-2) (5+2) (4+1) (7x33%)

To further elaborate on the fact that many HPEs don’t realize that because bonuses are not counted as part of income, LTD falls short of their income replacement requirements and expectations. I offer the following example.

Consider an HPE who earns $100,000 annually: The HPE may have $35,000 paid as a bonus and the remaining $65,000 paid as a salary. Under an LTD plan, the executive may wind up with only 26 percent after taxes (since bonuses are generally excluded from coverage).

$65,000 Salary
         60   LTD percent
$39,000   Before taxes (33 percent bracket)
$26,130   After taxes

This example further illustrates how LTD can be detrimental to one’s financial security! It should be noted at this point that I am not against LTD, nor will every provider of LTD have all of the negatives/disadvantages that are usually part of such a plan. As a rule, however, they will have many, if not all, of the disadvantages and shortcomings listed in Table 4 — certainly enough to make one want to rethink whether or not this “free” coverage is really a Trojan horse.

What type of coverage should an HPE have?

Clearly, the answer is an employee-paid individual non-can/guaranteed renewable plan, for the full amount of participation allowed by the carrier without any LTD coverage. This form of individual disability insurance (IDI) coverage then reverses all of the LTD disadvantages and offers some additional value-added features by becoming a claim-driven, rather than a contract-driven, policy.

How does the HPE pay for such a plan?

Certainly not out of the HPE’s pocket; it would be too expensive. Well, if the corporation was willing to pay the premium (not such a good idea; it makes the benefits taxable), why not have the corporation give a bonus to the employee for the same amount and have the employee pay the premium with the bonus? The bonus is still a business expense to the corporation, and the benefits will now become tax-free to the employee (IRC 104(a)(3)). In this case, the bonus amount will be included in the employee’s taxable income, but to create a zero tax cost to the employee, the tax due can also be paid with a bonus. If, on the other hand, the premium was paid by the corporation (IRC 162), this premium amount would be excluded from the HPE’s taxable income (IRC 106). However, benefits would have been taxed (IRC 105(a)). Table 6 summarizes the tax consequences at a glance.

This executive bonus plan can discriminate; it doesn’t even have to be offered to all executives, and no IRS or ERISA approval is required.

Table 6: Tax Consequences at a Glance
Premium Payer Benefits Payable To Policy Owner Tax Consequences: Premiums Benefits
Employer Employee Employer Deductible by employer (IRC Section 162) Employer’s contribution excluded from employee’s gross income (IRC Section 106) Reportable as income (IRC Section 105(a))
Employer and employee Employee Employee Employer’s contribution deductible by employer (IRC Section 162) Employer’s contribution excluded from employee’s gross income (IRC Section 106) Employee paid portion tax-free (IRC Section 104(a)(3)) Employer paid portion reportable as income (IRC Section 105(a))
Employee Employee Employee Not deductible (IRC Section 265) Tax-free (IRC Section 104(a)(3))
A. A tax credit for certain retirees and disabled individuals is provided by IRC Section 37. The credits apply to taxpayers who are (1) 65 or over, or (2) under the age of 65, but are retired due to total and permanent disability (within the meaning of the Social Security definition).

This Social Security definition states that “An individual is permanently and totally disabled if he is unable to engage in any substantial gainful activity by reason of medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.

B. Under disability income plans owned and paid for in whole or in part by the employer, FICA taxes must be paid by the employee and the employer on taxable benefits received by the employee during the first six months following the last calendar month in which the employee worked.

As you can see, including no plan at all (typical business plan), there are three choices: (a) typical business plan (no plan), (b) executive bonus plan and (c) employer-paid plan.

Table 7 illustrates what happens when three different employees become permanently disabled with three different results. From this table, you will observe that the executive bonus plan will pay more, and it costs less than the other two plans. Incidentally, under the typical business “no plan,” the IRS has already ruled that ad hoc payments (i.e., made to a disabled employee before a plan is put into effect) doesn’t allow these payments to be taken as a business expense.

Table 7: Three Key Employees Become Permanently Disabled with Three Different Results
Typical Business Plan (Ad Hoc) Executive Bonus Plan Employer-Paid Plan
Employer Tax Bracket:   40%
Employee earnings:   $100,000
Age at disability:   45
Disability plan: None
Employee Tax Bracket:   33%
Employee earnings:   $100,000
Age at disability:   45
Disability plan purchased 5 years ago, $4,000 annual premium
Employer-Paid Plan
Employee earnings:   $100,000
Age at disability:   45
Disability plan purchased 5 years ago, $4,000 annual premium
Disabled Employee Receives
Social Security Benefits Plus
60% of pay                    60,000
Minus taxes                  -19,800
Total after taxes            40,200
To age 65 (after taxes)                           $804,000
IRC 104(a)(3)
Social Security Benefits Plus
60% of pay                        $60,000
Minus taxes                                -0
Total after taxes                60,000
To age 65 (after taxes)                                $1,200,000
IRC 105(a)
Social Security Benefits Plus
60% of pay                          $60,000
Minus taxes                          -19,800
Total after taxes                  40,200
To age 65 (after taxes)                                    $804,000
Employer Cost
$60,000 x 20 years         $1,200,000
Tax deduction                           -0
Earnings required           $2,000,000
IRC 162
$5,970 x 5 years                  $29,851
Tax deduction                     -11,642
Earnings required               18,209
IRC 162
$4,000 x 5 years                     $20,000
Tax deduction                         7,800
Earnings required                  $12,200
Which Plan Would You Want for Yourself?
After Tax Cost — Benefit Analysis
Typical business plan cost           $2,000,000 to provide $ 804,000 After-tax benefit

Executive bonus plan cost           18,209 to provide 1,200,000 After-tax benefit

Employer-paid plan cost              12,200 to provide 804,000 After-tax benefit

To help the agent when providing an IDI supplement to the HCE, one should be able to recognize and overcome disability insurance (DI) underwriting land mines.

First off, what is a “land mine” in DI underwriting? A land mine is some sort of health or other type of condition/situation that, when submitted to an underwriter (or later detected by an underwriter during his or her scrutiny of the application and or medical records, etc.), could explode in the producer’s face. The application can/will be rejected, and the prospect, at the very least, is not going to be a happy camper. The applicant went through a lot to help get the application through the process — tax returns, examination, interview, etc. — and it could all be in vain.

Will the agent be blamed for not knowing any better when he or she submitted the application, not detecting and/or providing the land mine information in the first place? Probably. Could the agent lose the client and/or not get any more referrals? Perhaps. Did the situation have to happen? Probably not. How could the agent have known what to anticipate, and what could have been done if the agent had known?

First, let’s look at what it takes to get an application through the underwriting maze. Currently, the underwriter evaluates the applicant’s application, tax returns, MIB and health records and then conducts a personal history interview, all of which affects a decision to either issue a policy as applied for, issue with an exclusion/modification/rating or decline.

Typical land mines that can impact the process are as follows:

  • Health issues: physical (APS/exam) or mental/emotional (APS/exam)
  • New business
  • Occupation/duties
  • Working/traveling abroad
  • Working from home
  • Age (too old)
  • Income (too much, too little)
  • Hours worked
  • Other (pertaining to certain business applications)
  • Driving record
  • Dangerous activities

In order to avoid embarrassment and any inconvenience to your client, the above should help the agent to recognize that going through the normal channels for some of these underwriting dilemmas will probably be a waste of time and effort for all concerned and also have some negative consequences as well, depending on the exact circumstances. Why submit a questionable application only to find out weeks (sometimes six to eight) later that it has been declined when the problem could have been avoided in the first place?

What, if anything, can be done in view of the aforementioned in order to somehow get a policy issued? The first thing, besides knowing that a potential problem exists, is to have your prospect be made aware that any application misinformation or omissions can produce negative results in more ways than one and that full disclosure is the only solution to a possible successful resolution or conclusion. Of course, a cover letter addressing the issues in a more favorable light will help.

The next step for a successful outcome is to locate a disability insurance brokerage that specializes in hard-to-place disability coverage and enlist their help. Even so, some land mine situations typically might only produce a five-year benefit period/exclusions/rating, etc., although I have seen coverage issued that has been for a shorter/longer benefit period and without a rating or exclusion.

Are there other solutions or remedies? Yes, but are they worthwhile? One might be to wait for the land mine to disappear, but is this a good idea? No, I don’t believe so. I don’t believe waiting a few years for the problem to possibly disappear is a worthwhile decision, so with that view in mind, consider this: At least initially, a half loaf of bread is better than none! At least during this waiting period, your client has some coverage, and if/when the condition resolves itself, the exclusion/rating can be considered for removal, and if it was issued with a shorter benefit period than applied for, then, if feasible, the insured can reapply.

Rather than bouncing from one carrier to another, to save you time and effort, I would speak to someone who specializes in hard-to-place cases and who has access to carriers who will more than likely issue some form of coverage. Thereafter, when the problem has been satisfactorily resolved, your client can reapply to your first-choice carrier.

See below for possible outcomes and possible solutions.

Concerns:

  • Bad back
  • Mental/nervous
  • Etc.

Solutions:

  • Longer elimination period
  • Shorter benefit period
  • Smaller benefit amount
  • Rating/exclusion

Business application of disability income insurance and related tax considerations

Disability insurance: business funding needs

Now that you have provided your client with an IDI policy, which takes care of his or her personal needs (food, rent and the like), what other policies can also be provided in the event your client gets disabled and, as a result, cannot work? What if there are business expenses to be paid? What if the business has a partner, and the disabled partner wants to be bought out? What if there is a nonowner “rainmaker” in the company and that person becomes disabled?

You, as an agent or financial planner, should stress to your client that only having IDI isn’t enough; the client should also be concerned about keeping the business doors open and paying employees’ salaries while disabled as well as having the funds for a buyout.

Fortunately, there are policies specifically designed to remedy each of the aforementioned (and other) problems:

  • Business overhead expense (BOE): This policy will reimburse all covered expenses that are incurred as a result of a covered disability. This policy, like the IDI policy, has an elimination period and typically has a choice of three benefit periods (12, 18 or 24 months); it also has a tax-deductible premium (IRC 55-264). Benefits are taxable (IRC 55-264), but when the expense is paid, it becomes a tax deduction (IRC 162), and so there is a wipe.
  • Key man: This policy, when taken out on a key person (rainmaker), will provide a tax-free benefit (IRC 104(a)(3)) to the business in order to offset lost profits or to pay the disabled person while also paying the possible replacement. The premium is not a tax deduction (IRC 205).
  • Buy-sell: This policy provides a benefit amount available to the nondisabled partner so that according to the terms of the buy-sell agreement, the disabled partner must relinquish ownership of his or her shares. Typically, the elimination period is no less than 12 months (you don’t want to kick out your partner for just a broken leg, do you?), and benefits either be had on a lump-sum basis or a monthly payout (lower premium). The premiums are not tax-deductible (IRC 213, 265); however, benefits paid are tax-free (IRC 104(a)(3)). Legal counsel should always be sought.

Without such funding, where will the money come from? If the business takes out a loan, it could hurt the balance sheet if/when the business is sold.

There are basically two types of funding agreements, and these are referred to as cross-purchase and entity-purchase buy-sell agreements.

Under the entity-purchase (stock redemption), the company buys the policies for each of the shareholders or partners. The company is the owner, pays the premium and is the beneficiary of the policies. There’s also a sinking fund method.

With the cross purchase, each of the owners buys a policy on each other (cumbersome when there are more than two or three partners).

Carriers have valuation formulas to determine how much can be issued, and the business must periodically be reevaluated to make sure it is not over- or undervalued in terms of the benefit amount (no, these policies are not 100 percent non-can), and some carriers reduce the payout amount/premium once a covered partner reaches the age of 60. Some valuation methods are book value, straight capitalization, years purchased or any combo therein.

Types of disability income insurance:

  • Wage continuation plans
  • Individual
  • Business overhead
  • Key person
  • Buy-sell

Wage continuation plan tax implications:

  • Application: Wage continuation plans
  • Purpose: To provide income for lost wages when employee is disabled
  • Premium: Tax deductible to employer; not reported as taxable income to employee
  • Benefits: Taxable to employee

Individual disability plan tax implications:

  • Application: Individual
  • Purpose: To replace lost net earnings when insured is disabled
  • Premium: Not tax deductible
  • Benefits: Are tax-free

Business application of disability income insurance and related tax considerations:

  • Application: Business overhead expense
  • Purpose: To provide source of allowable expense income when owner is disabled
  • Premium: Tax deductible (IRC 55-264)
  • Benefits: Taxable (IRC 55-264)
  • Expenses paid: Tax deductible (IRC 162)

Frequently asked questions

What expenses are covered?

Covered expenses mean your share of the normal and customary business expenses, which you incur in the conduct of your business or profession and, except for scheduled depreciation, require a cash payment and which the U.S. Internal Revenue Service accepts as tax-deductible business overhead expenses.

Covered expenses include but are not limited to:

  • Either rent on space you occupy and use as business premises or scheduled depreciation or mortgage payments on those premises.
  • Property taxes
  • Installment payments or scheduled depreciation for furniture and equipment
  • Salaries of employees, including employer contributions for FICA taxes and qualified benefit programs, except as listed under “Expenses not covered”
  • Utilities
  • Premiums for business insurance including malpractice insurance, except as listed under “Expenses not covered”
  • Accounting, billing and collection fees
  • Fees for business or professional licenses
  • Association or trade dues and subscriptions
  • Postage
  • Business laundry
  • Janitorial and maintenance services

What expenses are not covered?

Expenses not covered are:

  • Some policies (not all) do not cover salaries, wages, commissions or any other remuneration or employer contribution for you or for any principal in your business or for any member of your profession or for any person employed to perform your duties.
  • Any financial obligations, including insurance premiums, which are waived during your disability
  • The cost of any goods, merchandise or inventory
  • Any expense for which you were not periodically liable before the start of disability
  • That portion of normal and customary business expenses, which is the obligation of any person other than yourself
  • Overhead expenses, which would be covered under this policy were it not for such expenses being paid under another insurance policy issued prior to the issue date of this policy

When will disability benefits begin?

When you are disabled under the terms of the policy, benefits will begin after you have satisfied the elimination period. The elimination period is the number of months for which the carrier will not pay benefits at the start of a claim.

You must be disabled from the same or a different cause for this entire period. The accumulation period can be a period of consecutive months that begins on the first day that you are disabled and during which the elimination period must be satisfied.

What happens if I have a recurrent period of disability?

After the elimination period has been satisfied, recurrent periods of disability will be considered one continuous period of disability if they result from the same cause or causes and are not separated by a recovery of more than six months. If a recurrent period of disability arises from a different cause, carriers will usually consider your loss to be a separate and unrelated period of disability.

If I am disabled, will I have to pay premiums on the policy?

If you are disabled for at least three months (or the length of the elimination period, if shorter), carriers will refund any premiums due and paid during that period. Then they will waive any later premium that falls due while you are continuously so disabled or, in some cases, within three months after you recover.

Is there a presumptive total disability benefit?

Yes. Carriers will usually consider you to be totally disabled, even if you are at work, if sickness or injury results in your total and complete loss of the sight of both eyes; hearing of both ears; power of speech; or the use of two arms or two legs or one arm and one leg, in their entirety.

Is there a transplant and cosmetic surgery benefit?

Yes. If you become totally disabled because of the transplant of a part of your body to another person, or have cosmetic surgery to improve your appearance or correct a disfigurement, some carriers will deem you to be disabled as a result of sickness.

Is there a survivor benefit?

Yes. If you die as a result of sickness or injury while the policy is in force, some carriers will pay benefits from the date of your death for up to three months for covered expenses incurred to maintain your business.

Business overhead expense (BOE) features:

  • Guaranteed renewable/non-cancelabl
  • Elimination periods: 30/60/90/days
  • Benefit periods: 12/18/24/months
  • Benefit amounts: $1,000 to $30,000
  • Premium tax deductible: Yes
  • Benefits taxable: Yes
  • Paid expenses deductible: Yes
  • Covered expenses (rent/electricity/employees salary replacement expense): Yes
  • Own-occupation: Yes
  • Carryover: Yes
  • Residual: Yes
  • FIO: Yes

Wage continuation plan tax implications:

  • Application: Key person
  • Purpose: To reimburse owner of business to offset expenses when hiring replacement for a key person
  • Premium: Not tax deductible
  • Benefits: Tax-free

Key employee disability coverage

Key man/person underwriting considerations; very strict underwriting; still experimental in the industry:

  • How does the loss affect the business?
  • Are there other employees who can step up to the plate?
  • Benefit periods: Usually two to five years
  • Benefit payable to: The business

Individual disability plan tax implications:

  • Application: Buy-sell
  • Purpose: To provide funds to the nondisabled person in order that the disabled person may receive a sum for their shares
  • Premium: Not tax deductible
  • Benefits: Tax-free
  • Trigger date: Usually 12 months
  • Agreement: Seek counsel

Disability buy-sell plans

Any policy funding a disability buyout agreement is considered to be a capital transaction, and therefore premiums are not deductible. The benefits, then, are not taxable as income. You should be aware, however, that there may be tax on the sale of the business interest itself. If the disabled owner gets more dollars for his share than he originally put into the business, the amount of the gain is taxable.

Table 8
Premium Paid By Policy Owner/Benefits Paid To Tax Treatment Premium Tax Treatment Benefits
Partnership Entity Purchase Individual Not deductible IRC Sec. 265 Tax-free IRC Sec. 104(a)(3)  
Partnership Cross Purchase Insured’s partner Not deductible IRC Sec. 265 Tax-free IRC Sec. 104(a)(3)
Corporation Entity Purchase Corporation Not deductible IRC Sec. 265 Tax-free IRC Sec. 104(a)(3)
Corporation Cross Purchase Individual shareholder Not deductible IRC Sec. 265 Tax-free IRC Sec. 104(a)(3)

Buy-sell key features

Total disability benefit

Total disability means that because of sickness or injury, the insured is not able to perform the major duties of his or her occupation and is not at work for the business entity. Occupation means the insured’s regular occupation at the time of disability.

Payment of benefits

Benefit payments begin after the insured has been totally disabled for the length of the elimination period or, if later, on the date the buy-sell occurs. Both the policy and the buy-sell agreement must be in effect when total disability begins. There is no requirement of total disability after the buy-sell occurs. Except for the guaranteed benefit, payments end at death.

Three flexible funding methods

There are three funding methods available, your choice to be indicated at the time of issue.

  1. Monthly funding method: Under this method, carrier will pay at the end of each month the actual monthly purchase price up to the monthly benefit limit.
  2. Down payment/monthly funding method: If a combination down payment/monthly funding method is selected, carrier will pay a lump sum equal to the actual down payment paid as part of the purchase price, not to exceed the down payment benefit shown in the policy. At the end of each month after that, carrier will pay the actual monthly purchase price, but not more than the policy’s monthly benefit limit.
  3. Lump-sum funding method: If the lump-sum method is chosen, carrier will pay the actual lump sum paid as the purchase price, up to the maximum benefit limit. In lieu of a lump sum, the benefit can be paid in guaranteed installments over a period of 10 years or less.

Guaranteed benefit

If the insured dies while monthly benefits are being paid under the policy, some carriers will pay to the loss payee an amount equal to three times the monthly benefit limit. This provision does not apply to the lump-sum funding method.

Waiver of premium

After 90 consecutive days of total disability, premiums paid for each day during those 90 days will be refunded on a pro rata basis. After that, any premiums that fall due during that period of total disability will be waived and might continue to be waived for 90 days after recovery.

Interrupted elimination period

A break in the elimination period could be allowed (depending on the carrier) if it doesn’t last longer than six months. Then, if the insured is again totally disabled from the same or a different cause, the different periods of disability will be combined to determine when benefits become payable.

Future increase option rider (AR491)

This optional benefit allows you to purchase additional disability benefits in the future, with no evidence of good health required. On each option date, through age 50, up to 10 percent of the maximum benefit limit may be (depending on the carrier) purchased. If coverage is not increased on any option date, up to 20 percent of the maximum benefit limit will be available on the next succeeding option date.

The waiver of premium benefit also applies to the future increase option rider.

$1 million?

Your partner’s disability could cost you that much if your buy-sell agreement has a page missing. Few owners realize that, as far as their business is concerned, there is no real difference between actual “physical” death and the “living and economic” death caused by an owner’s lengthy disability. Yet chances are that your buy-sell agreement lacks a disability buyout provision.

What to do about the missing page

The absence of such a provision could mean:

  • That it was overlooked by business planners
  • That there was an unfamiliarity with the concept of the disability buyout
  • That the owners felt the cash required would not be available when needed to fund the agreement

Your business disability buyout policy can help provide the balance of cash flow necessary to allow you to buy your disabled associate’s business interest. Business disability buyout is a policy scaled to the needs of both the healthy and the disabled owners.

Advantages to healthy owner

  • The healthy owner(s) maintains 100 percent ownership and continuity of management.
  • There is a smooth transfer of interest because the conditions of the buyout, the purchase price (or formula) and the funding method have been predetermined.
  • The firm’s continued existence is assured, and profits will not be depleted.
  • Insurance proceeds are usually received income tax-free.

Advantages to disabled owner

  • Disabled owner is assured of a buyer at a predetermined and fair price.
  • Disabled owner receives cash for his or her share of the business.
  • There is freedom from the risk of future company losses.
  • Family members won’t have to become involved.

Consider the odds

You may not like to think about it, but the odds are high that either you or one of your business associates will suffer a disability of one year or more before age 65.

Table 9
Age Number in Group
  1 2 3 4 5
25 11.67% 21.98% 31.09% 39.13% 46.23%
30 11.34% 21.40% 30.31% 38.22% 45.22%
35 10.98% 20.75% 29.45% 37.19% 44.09%
40 10.50% 19.90% 28.31% 35.84% 42.58%
45 9.83% 18.70% 26.69% 33.90% 40.40%
50 8.83% 16.88% 24.21% 30.90% 37.00%
55 7.24% 13.96% 20.19% 25.97% 31.33%
60 4.61% 9.02% 13.21% 17.22% 21.04%

Source: 1985 Commissioners Disability Table (male, based on 30-day elimination period) combined with the 1980 Commissioners Standard Ordinary Mortality Table.

Disability buyout tax facts

  • Premiums paid by partnerships and corporations are not deductible, but benefits are received tax-free (IRC 265; IRC 104(a)(c)). In some situations, the alternate minimum tax may apply. Please consult with a tax advisor.
  • A shareholder’s interest in a corporation is a capital asset. Hence, whether purchased by the corporation or a third party, the purchaser of the interest cannot deduct his or her payment for federal income tax purposes.
  • Where there is a total redemption of a shareholder’s shares, the payment he or she receives will be treated as a capital gain or loss. If the redemption is less than total, the payments may be deemed to be dividends and, hence, ordinary income to the shareholders, even though they are not deductible by the corporation (IRC 302).
  • When an installment buyout takes more than one year, a minimum interest rate is set by the IRS and must be paid by the purchaser on the declining balance of the payments, or a higher percent interest may be imputed (IRC 483).

Why fund your agreement with disability insurance?

Although a disability buyout provision is a necessity, a buy-sell agreement can become a worthless document if not properly funded. It is easy to see that disability insurance can provide the necessary cash required to complete the disability buyout and eliminate uncertainties about the availability of required cash.

Methods of funding a buy-sell agreement for $1,000.000

Method: Cash/Cost – after-tax dollars

  • Will the cash available now be available at some unknown future date?
  • Will this cash be needed for other business purposes?
  • Can the business survive a large cash depletion?

Method: Sinking fund/Cost – after-tax dollars

  • Will there be time to accumulate the necessary cash?
  • Will this cash be needed for other business purposes?

Method: Installments from future earnings/Cost – after-tax dollars plus interest

  • Will future earnings be adequate?
  • Will the future installment obligation impair the firm’s ability to borrow?
  • What will the interest cost?
  • Will the future earnings be needed for other business purposes?

Method: Borrowed money/Cost – after-tax dollars plus interest

  • Will borrowed money be available?
  • What will the interest cost?
  • Will the repayment schedule plus interest place the business in a financial bind and impair expansion?

Method: Insurance/Cost – discounted dollars

  • Cash available at unknown future date when needed
  • Choice of three flexible payout methods rather than unpredictable interest cost
  • Future earnings left unimpaired
  • Other cash assets of business available for other business purposes

Plan design: Cross purchase versus entity purchase

Many factors are involved in determining whether to establish the buy-sell plan as a cross purchase or an entity purchase.

Some of these factors include:

  • Are the owners or the company in the best position to pay the premium?
  • Is a step-up in basis desired?
  • How many owners are involved in the plan?

Your client should consult with a tax attorney or CPA for advice on the best arrangement for his or her business and personal situation. In summary, here are the highlights of each.

Cross-purchase arrangement

The individual owners (not the business) own the policies, pay the premium and receive the policy benefits if a colleague becomes disabled. This type of arrangement is usually implemented when there are few owners, since many owners would necessitate a large number of policies.

Tax implications of cross-purchase arrangement:

  • The premiums paid by the owners are not tax deductible.
  • The policy benefits received by the remaining owners are excludable from gross income.
  • The remaining owners receive a step-up in basis.

Entity purchase arrangement

The business (not the individual owners) owns the policies, pays the premiums and receives the policy benefits if an owner becomes disabled. This arrangement is often used when there are many owners because it reduces the number of policies needed to implement the plan.

Tax implications of the entity purchase arrangement:

  • The premiums paid by the business are not tax deductible.
  • The policy benefits received by the business are excludable from income.
  • The remaining owners receive no step-up in basis. However, in some circumstances, there may be a partial step-up in basis for the remaining partners in a partnership. Your client should consult with his or her tax attorney or CPA.

Choosing the payout method

At the time of application, your client must establish the benefit payout option he or she desires. Two options are available:

  1. Flexible funding method: At the time of claim, the policyowner can choose a single lump sum, interest-bearing monthly payments or any combination of lump sum and interest-bearing monthly payments. The maximum payout period is 10 years. Benefit payments continue if the insured dies.
  2. Monthly installment method: This plan provides for benefits to be paid in 60 equal monthly installments, noninterest bearing. Payments will cease at the death of the insured.

Explanation of terms, disability buy-sell, business valuations

It is important to realize that there are no “correct” rates or factors used in disability buyout business valuation. Even the IRS uses different rates and factors for the same items under the same or different circumstances.

Book value

Book value is the net worth of a business expressed as “assets less liabilities.” Business assets may be valued at fair market value, cost or their depreciated value. To reflect an accurate value of a business, the fair market value of assets should be used. This means that assets carried at cost or depreciated would have to be adjusted.

Average annual earnings

This is the average net annual earnings of a business after taxes during the past two, five or even 10 years or more.

To determine the net annual earnings, deduct from the gross earnings all legitimate business expenses including income taxes.

Interest assumption on book value

This is the rate of return an investor would expect to receive from this type of business. This is a subjective analysis based upon the risk involved, general economic outlook and current interest rates.

Normally, the interest assumption would be higher than current insured or “safe” investments, such as bank accounts, certificates of deposit and money market accounts.

Years goodwill expected to last

“Goodwill” is often defined as the expectation that future profits will continue under the ownership of someone other than the present owner(s). The following factors, although not all inclusive, are fundamental and require careful analysis in order to determine the number of full years goodwill is expected to last:

  • The nature and type of the business (service, manufacturing, C corp., partnership, etc.)
  • The length of time the business has been in existence (i.e., one to two years, three to five years, five years or more)
  • The number of active business owners

For medical, dental, legal and accounting professional corporations and personal service partnerships (including insurance agencies), goodwill is excluded for buyout valuation purposes.

Capitalization rate

The capitalization rate is the desired rate of return an investor would be willing to accept for the given level of risk. A high-risk investment would equate to a high capitalization rate, which in turn results in a lower business value. A smaller capitalization rate will result in a higher business value.

A stable business with a large capital asset base and established goodwill will be a less risky investment and should be assigned a lower capitalization rate than a small business with little capital, financial history or management depth. Assign a high capitalization rate to a personal business that depends on the presence of only one or two key people. An investor purchasing this type of business would want a high rate of return as a reward for that risk.

One method in determining the capitalization rate is by dividing 100 by the interest assumption and book value (previously selected). For example, if an investor was willing to accept a 15 percent rate of return on his or her money, the capitalization rate would be 6.67 (1 ¸ 15).

Multiplying this factor by the average annual earnings will produce the straight capitalization value.

Summary

Table 10 sums up the tax implications of various disability income plans.

Table 10: Tax Summary of Disability Income Insurance
Disability Income — Employer/Employee Wage Continuation
Policy Owner: Employee Proceeds Payable To: Employee Premium Payor: Employee Tax Consequences Premium: Nondeductible (IRC 213) Proceeds: Excludable (IRC 1040(3))
Employee Employee Employer/ Employee Nondeductible by employer (IRC 213) Deductible by employer (IRC 162) Excludable (IRC 106) (Employer contribution only) Taxable/Excludable (IRC 104(a)(3))
Employee Employee Employer Deductible by employer (IRC 162) Excludable (IRC 106) Taxable
Disability Income — Individuals/Sole Proprietor/Partnership/Corporation
Policy Owner Proceeds Payable To Premium Payor Tax Consequences Premium Proceeds
Individual Individual Individual Nondeductible (IRC 213) and (IRC 262) Excludable (IRC 104(a)(3))
Sole proprietor Sole proprietor Business (same as owner for tax) Nondeductible (IRC 213) Excludable (IRC 104(a)(3))
Partner Partner Partnership Nondeductible (IRC 265) Excludable (IRC 104(a)(3))
Corporation Corporation Corporation Nondeductible (IRC 265) Excludable (IRC 104(a)(3) Sole
Proprietor Sole proprietor Business Deductible (Rev. Rul. 55-264, 1955-01 C.B. 11) Nonexcludable+ (Rev. Rul. 55-265, 1955-1 C.B. 11)
Partnership Partnership Partnership Deductible (Rev. Rul. 55-264, 1955-1 C.B. 11) Nonexcludable+ (Rev. Rul. 55, 265, 1955-1 C.B. 11)
Corporation Corporation Corporation Deductible (Rev. Rul. 55-264, 1955-1 C.B. 11) Nonexcludable+ (Rev. Rul. 55-265 1955-1 C.B. 11)
The proceeds attributed to employer contributions are taxable income to the recipient; proceeds attributable to employee contributions are excludable.

While the proceeds are taxable, the actual business expenses are deductible items.
Disability Buyout (Premiums and Proceeds)
Regardless of the form of buyout, be it entity or cross purchase, premiums paid for disability insurance to fund nondeductible under IRC 264(1), 265 and Rev. Rul. 66-262, 196602 C.B. 105, and proceeds are received tax-free under IRC 104(a)(3).
Disability Income Tax Credit
Under IRC 22, a limited credit (up to 15% of the base amount) is available for permanently and totally disabled individuals under age 65.
Schneider

Larry Schneider has exclusively specialized in disability insurance since 1972, publishing more than 50 articles on the subject and serving as a trainer and seminar speaker during that time. He was a claims consultant and expert witness panelist at a litigation conference and rewrote the American College's disability insurance manual.

 

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