This series on the finances of disability insurance has focused mainly on disability income insurance because it is the most common type of disability insurance, but there are several others that warrant discussion. In addition to disability income insurance, there are also business overhead expense policies, key-man policies, and buy-sell policies. Agents offer these policies as stand-alone products or as part of a disability risk management plan for business owners and other individuals who are vital to the everyday well-being of the company. These highly specialized policies each have their own separate rules and are taxed accordingly.
One important caveat about this series of blogs on taxes and disability benefits: If you have any questions about the taxability of your specific disability benefits, please consult your tax preparer, or a claims advocate who has experience dealing with the financial issues in disability claims.
Business overhead expense insurance is the most common type of disability insurance other than disability income policies. These policies are usually purchased by the owner of a business to keep the bills paid while dealing with their disability. Unlike other types of insurance, these policies are usually more of a reimbursement than a direct benefit. They will cover fixed expenses of a business up to a certain limit and are short-term policies, with benefit periods commonly less than 36 months. As an example, if an overhead expense policy provides for up to $2,500 of monthly benefits and the business has $1,700 of overhead expenses in a month, the policy pays $1,700 for that month. Because premium payments are usually paid by the business for overhead expense policies, these benefits are reported as income on the company’s financial records and are taxed along with the rest of the business income. Occasionally overhead expense benefits are recorded as negative expenses rather than revenues, but this would have no net difference on the taxability of the benefits.
Key-man insurance helps the continuity of a business in case an invaluable member of its management team is lost to a disability, and the company suffers financially because of the loss. Insurance companies will usually not issue these policies for individuals who are not considered critical to the company, so these policies are only written for key executive owners of businesses. The monthly benefits for these types of policies are usually paid directly to the business but don’t depend on the actual expenses of the business, unlike the reimbursement payments from business overhead expense policies. Key-man benefits are usually taxed in a manner quite similar to business overhead expense benefits however. Since it’s the company receiving the benefits rather than the individual, the payments are recorded as income and taxed at the effective tax rate of the business.
Buy-sell insurance is among the most complicated of the more specialized disability policies. This policy protects two or more owners in a business if one of them were to become disabled. The policy provides the funds necessary to buyout the ownership share of the disabled partner. Buy-sell policies require a minimum of two owners but can include as many owners as needed. Most buy-sell policies have a 12 month elimination period, and the business is only eligible for benefits if the disabled owner is considered to be totally disabled according to policy language. There are no monthly benefits but rather a lump-sum payment at the end of the elimination period. Because the benefits are used to fund the buy back the ownership share from the disabled partner, it is considered a capital transaction and the funds are not taxed at the business level. However, the disabled owner who eventually receives the buy-out will report the applicable capital gain on his personal tax return.
These forms of disability insurance are great protection if your needs fall into one of their categories. Many employers and business owners don’t realize the values of these policies and how they can help protect important aspects of their business and in turn, their personal income. As most business owners will tell you, the survival of the business is just as important as their income. If you have any experience with these types of insurance claims, please tell your story in the comments below. If you have any further questions, please call us at (855) 828-4100 or visit our website.