Which is true about disability buy-sell insurance policies?

The tax treatment of disability buy-sell insurance follows a standard principle: if the premiums are not tax-deductible, the benefits are received income tax-free. In a disability buy-sell arrangement, the business entity or the individual partners pay the premiums with after-tax dollars. The premiums are not considered a deductible business expense. Consequently, when a triggering disability occurs, the policy proceeds paid to the business or the surviving partners (the beneficiaries) are not subject to income tax. This ensures the full benefit amount is available to fund the purchase of the disabled owner's business interest as stipulated in the buy-sell agreement.

A. The policyowner may not be the beneficiary

The policyowner (the business or other owners) is almost always the beneficiary to ensure they receive the funds to execute the buyout.

B. The insurer pays the benefits to the disabled individual

Benefits are paid to the policyowner/beneficiary (the business or partners), who then uses the funds to purchase the disabled owner's share.

D. The premiums are tax-deductible

Premiums for disability buy-sell insurance are not considered a deductible business expense by the Internal Revenue Service (IRS).

1. Internal Revenue Service (IRS). (2023). Publication 535, Business Expenses. Chapter 6, "Insurance." This publication clarifies that premiums paid on a disability policy that covers an officer, employee, or any person financially interested in the business are not deductible if the taxpayer (the business) is directly or indirectly a beneficiary under the policy.

2. Internal Revenue Service (IRS). (2023). Publication 525, Taxable and Nontaxable Income. Page 15, "Sickness and Injury Benefits." This publication explains that benefits received from a disability policy are not taxable income if the premiums were paid with after-tax money. Since buy-sell premiums are not deductible (per Publication 535), the corresponding benefits are received tax-free.

3. University of Minnesota Extension. (2021). Transferring the Farm Business to the Next Generation. Section on "Buy-Sell Agreements." This university resource discusses the use of insurance to fund buy-sell agreements, noting that disability buy-sell policies provide tax-free cash to the business or remaining owners to purchase the disabled owner's interest.