Buy-Sell Disability Insurance Simplified: A Step-by-Step Guide for Canadians

Business partnerships and corporations with multiple owners need comprehensive buy-sell agreements to protect all parties in the event one becomes disabled or passes away. However, even the most ironclad agreement is ineffective without properly funding it. This is where buy-sell disability insurance becomes invaluable for Canadian businesses.

This extensive guide provides an in-depth look at buy-sell disability insurance, who needs coverage, how it works, key features and benefits, potential drawbacks, and expert tips for purchasing optimal policies to protect Canadian businesses now and into the future.

What is Buy-Sell Disability Insurance?

Buy-sell disability insurance provides the funds for remaining business owners or shareholders to purchase a disabled partner or shareholder’s interest in a company at fair market value. This special type of business insurance pays either a lump sum benefit or installments to the business entity, which then utilizes the money to buy out the disabled owner’s shares as stipulated in the buy-sell agreement.

These buy-sell disability policies allow partnerships, corporations, and other entities with multiple owners to continue operating smoothly when one or more partners or shareholders become totally and permanently disabled and can no longer actively contribute to the business.

To execute a funded buyout, the business owners or shareholders must first have an up-to-date buy-sell agreement in place that clearly details the terms, conditions, valuation methods, and triggering events for buying out an owner’s interest in the company. A well-structured buy-sell agreement protects both the departing disabled owner and the business itself.

The buy-sell disability insurance policies provide the crucial financing means for the entity to carry out the buyout of a disabled owner’s interest as agreed upon in the buy-sell agreement. These policies pay out when the insured partner or shareholder becomes totally and permanently disabled, as specifically defined in the individual insurance policy contracts.

In most policies, benefits are triggered after an initial waiting period, commonly 12 months after the onset of disability. This waiting period gives the disabled business owner a chance to recover and return to work before executing the full buyout agreement.

Vital Disability Statistics & Data in Canada

Before diving into the details of buy-sell disability insurance, it’s important to understand the prevalence of disability across Canada. Reviewing key statistics and data paints a clear picture of how disability affects working-age Canadians:

• 22% Canadians live with some form of disability, according to Statistics Canada. This includes mild, moderate, and severe disabilities. (Source)
• Almost 45.1% of working-age Canadians have at least one chronic health condition. The most common are arthritis, asthma, heart disease, diabetes, cancer, depression, and anxiety. (Source)
• Over 1.5 million working-age Canadians have a disability that limits their ability to work at home, engage in the community, or participate in education or employment. (Source)
• The table below shows the percentage of Canadians affected by disabilities based on age group:

This data highlights that the probability of experiencing a long-term disabling condition is far from negligible, even for younger Canadians.

With the significant chance of permanent disability striking any business partner before retirement age, having buy-sell disability insurance in place to protect both the departing and remaining owners is a wise investment. These policies provide invaluable peace of mind that a partner buyout due to disability won’t sink the business.

Buy-Sell Agreement Overview

Before detailing how buy-sell disability insurance works, it’s important to understand buy-sell agreements in general.

A buy-sell agreement, sometimes referred to as a buyout agreement, is a legally binding contract between business partners, shareholders, or other co-owners of a company. This agreement governs what happens when a specified triggering event occurs, such as an owner’s death, disability, retirement, or termination of employment.

The main goals of a properly structured buy-sell agreement are to:

• Maintain business continuity and stability during ownership transitions
• Avoid forced liquidations that could sink the company’s value
• Facilitate smooth transfer of departing owner’s interest to remaining owners
• Prevent divisive disputes or litigation between current and past owners
• Outline clear valuation methods to establish fair buyout terms

Specifically for shareholder or partner disability, the agreement should clearly define the following:

• What happens to the disabled owner’s shares – who has the option or obligation to purchase them
• The valuation method to establish a fair buyout price
• The triggering events and definitional requirements of disability to activate the buyout
• How the buyout will be funded

The final three points should directly coordinate with the buy-sell disability insurance policies being utilized to fund the buyout. For example, the buyout triggering definition of disability, waiting period, required documentation, etc., should align between the agreement and insurance contracts to prevent gaps in coverage.

Having a rock-solid buy-sell agreement negotiated with the input of legal and tax professionals is a mandatory first step before considering buy-sell disability insurance. The policies provide financing means to execute the documented buyout plan in the event of an owner’s qualifying disability.

Read more: Buy-Sell Agreements in Canada

How Does Buy-Sell Disability Insurance Work?

Buy-sell disability insurance policies come in two primary structures: cross-purchase plans and stock redemption plans. The key difference lies in who purchases the insurance policies.

Cross-Purchase Buy-Sell Disability Insurance

With a cross-purchase agreement, the co-owners personally buy individual disability insurance policies for each of the other owners. The owners are responsible for paying the premiums on the policies in which they are the owners and beneficiaries.

If any business partner becomes disabled as defined in the buy-sell agreement, the remaining owner(s) utilize the payout from their insurance policy on the disabled partner to buy out their shares in the company at the predetermined price.

This structure is most common for businesses with just two co-owners, as only two policies need to be purchased. For entities with more than two owners, a separate cross-purchase buy-sell disability insurance trust is often established to hold the policies and facilitate the buyout.

The main advantage of the cross-purchase structure is that buyout proceeds are not subject to corporate taxes. Disadvantages include the number of policies required as the number of owners increases.

Stock Redemption Buy-Sell Disability Insurance

In a stock redemption plan, the corporation itself purchases an individual disability insurance policy for each business owner or shareholder. The company owns the policies, pays the premiums, and is the beneficiary of any payout.

If any shareholder or partner becomes disabled as defined in the agreement, the corporation, as the policy owner, receives the insurance benefit. It then utilizes the funds to buy back the disabled owner’s shares and redistribute ownership per the buy-sell agreement terms.

A main advantage of the stock redemption structure is consolidating all policies under the business entity. The disadvantage is that benefits may be subject to corporate taxes before distribution to remaining owners.

Both policy premiums and benefits have additional tax considerations covered in the section below. But in both structures, the buy-sell disability insurance provides the crucial funding means to execute the predetermined buyout plan if an owner meets the disability conditions.

Who Needs Buy-Sell Disability Insurance?

Buy-sell disability insurance is most applicable for:

• Canadian partnerships, LLCs, and closely-held private corporations with 2-10 co-owners
• Companies worth over $50,000 in value
• Businesses in stable service industries such as accounting, law, healthcare, technology, manufacturing, engineering, architecture, and more

Larger public corporations with dispersed shareholders are usually ineligible for buy-sell disability coverage. Spouses and certain family relations also often don’t qualify.

Additional requirements may include:

• Owners must be actively involved in the company’s operations
• Minimum percentage ownership, often 10-30%
• The minimum number of years the business has been operating
• Mandatory shareholder or partnership agreements
• Limits on owner age, often 60-70 years old

In short, Canadian businesses with a small, tightly knit ownership group, in operation for several years, with owners actively contributing to operations, make ideal candidates for buy-sell disability insurance. However, eligibility should be verified with an insurance advisor’s assistance.

What Are The Key Features and Benefits of Buy-Sell Disability Insurance?

Some of the top features and benefits of buy-sell disability insurance policies in Canada include:

Guaranteed Renewable – The insurance company cannot cancel the policy as long as premium payments are made on time. The coverage cannot be altered or terminated based on changes in the insured’s health or disability status either.

Level Premiums – Premium amounts are locked in based on the insured’s age at the time of purchase. Premiums will not increase just because the insured gets older, providing stable long-term costs.

Waiver of Premium – After the waiting period when benefits begin, no more premium payments are due, even if coverage stays in place. The insurer waives additional payments while the insured remains disabled.

Business Continuity – Allows the company to continue operating with minimal disruption if an owner becomes disabled. The buyout is pre-planned so the remaining owners can move forward.

Fair Buyout Value – Ensures a fair buyout price for the disabled owner based on objective business valuation methods detailed in the agreement rather than emotion.

Death Benefit – Some policies may include a reduced lump sum death benefit if the insured dies shortly after purchase, providing an additional layer of protection.

These powerful benefits provide Canadian business owners peace of mind that a partner’s disability won’t derail the company’s future or shortchange the departing owner.

Typical Coverage Amounts and Options for Buy-Sell Disability Insurance

Several important factors determine appropriate buy-sell disability insurance coverage amounts and options:

Business Valuation – The benefit amount should match the predetermined fair market buyout price based on ownership percentage. Estimates using revenue multipliers or professional valuations give suitable estimates.

Ownership Percentage – Benefits fund the buyout cost for the disabled owner’s proportional interest based on their ownership stake at the onset of disability.

Total vs. Individual Limits – Insurers limit the total coverage that can be purchased on all owners combined and the maximum on each individual owner.

Elimination Period – Length of the waiting period before benefits begin. Typical options are 12, 18, or 24 months. Longer periods have lower premiums.

Payout Options – Choice of lump sum, installments over 5-10 years, or partial lump sum with ongoing installments. Installments allow spreading tax liability.

Inflation Rider – An optional rider to increase the base benefit amount over time, matching inflation or company growth, without renewed underwriting.

Working with an experienced insurance advisor ensures your business buys sufficient buy-sell disability coverage structured optimally to enact the buyout agreement effectively if the need arises.

Tax Considerations for Buy-Sell Disability Insurance

Some key tax considerations for both cross-purchase and stock redemption buy-sell disability plans include:

• Premiums paid are not tax deductible by either the business or owners for Canadian tax purposes.
• Benefits paid are received tax-free by either the business entity or remaining owners who utilize the funds to purchase the departed owner’s shares.
• The disabled business owner who is bought out realizes a taxable capital gain on the difference between their buyout proceeds and the cost basis of their shares. However, the capital gain may qualify for the lifetime capital gains exemption.
• Stock redemption plans result in the initial lump sum payment being classified as a deemed dividend paid from the corporation to the disabled owner, which may have less preferential tax treatment.

Consulting with accounting and legal tax professionals when establishing your buy-sell agreements and disability insurance plans is highly recommended to optimize after-tax results.

What Are The Drawbacks of Buy-Sell Disability Insurance?

While buy-sell disability insurance provides invaluable protection and peace of mind, some drawbacks to consider include:

• Premiums Not Deductible – A key disadvantage compared to some other business insurance types.
• Partially Taxable Benefits – Creates a taxable capital gain for disabled owners bought out in a cross-purchase plan.
• Not a Retirement Vehicle – Unlike life insurance, no benefit is paid if an owner fully retires while still healthy.
• Not for Everyone – Eligibility restrictions and underwriting means some owners won’t qualify for coverage.
• Complex Set-up – Requires well-crafted buy-sell agreements, business valuations, ownership alignments, and tax optimizations.
• Administration – Ongoing tracking of ownership changes, business value, policy renewals, and premium payments.

None of these drawbacks outweigh the huge advantages for most privately-held Canadian companies. However, these considerations should be evaluated with the guidance of professionals to optimize the implementation.

What Does Buy-Sell Disability Insurance Cost in Canada?

Disability buy-sell insurance premiums vary substantially based on these key factors:

Age – Older business owners pay higher premiums. Rates lock in at the time of purchase.

Health – Those with medical conditions pay higher premiums or may be declined.

Occupation – More hazardous professions have higher rates.

Number of Owners – More owners covered reduces per-person costs.

Coverage Amount – Higher benefit amounts mean higher premiums.

Waiting Period – Longer periods before benefits start significantly reduce costs.

Riders – Additional riders like cost-of-living increases also raise costs slightly.

In general, younger, healthy owners in safe occupations buying higher coverage amounts and shorter waiting periods pay the highest premiums. Working with an experienced advisor helps minimize costs while still providing sufficient protection.

How to Purchase Buy-Sell Disability Insurance in Canada

Here is an overview of the key steps for Canadian businesses to purchase buy-sell disability insurance:

1. Have an up-to-date, well-drafted buy-sell agreement – This is the mandatory foundation before securing funding policies.

2. Accurately value the business – This determines the share purchase amounts upon an owner’s disability. Use a professional valuator for the most accurate estimate.

3. Select optimal policy structure – Choose either cross-purchase or stock redemption based on owners’ preferences and tax considerations.

4. Calculate sufficient coverage amounts – Factor ownership percentages and business value to determine the benefits needed.

5. Work with an insurance advisor – An experienced broker helps navigate options, training, applications, and policy structures.

6. Complete medical underwriting – All owners must complete individual health assessments and qualify based on their risk factors.

7. Coordinate with buy-sell agreement – Ensure definitions, terms, qualifying disability criteria, and all details align between both documents.

8. Implement and maintain policies – Regularly review to ensure adequate coverage as company value increases over time.

While the process involves multiple steps, an expert insurance advisor can guide business owners through efficiently putting sound buy-sell disability insurance in place.

Professional Tips for Purchasing Buy-Sell Disability Insurance

When shopping for buy-sell disability insurance, keep the following professional tips in mind:

• Bundle with other business policies like life insurance for multi-policy discounts.
• Extend the waiting period to lower premium costs, but not excessively long.
• Add a cost-of-living adjustment rider so benefits keep pace with inflation.
• Align ownership percentages, valuation methods, and payout terms between the buy-sell agreement and insurance policies.
• Consider an additional lump sum policy to cover potential income taxes triggered by the buyout.
• Review business valuation and coverage adequacy when revenue, profitability, or ownership stakes change materially.
• Pay premiums on time and keep policies in force to avoid losing this important coverage.
• Work with qualified legal and tax professionals to optimize agreement terms and tax treatment.
• Document all details thoroughly regarding policies, agreements, ownership changes, value assessments, and contact info for successor owners.

Frequently Asked Questions (FAQs)