Disability Gap and Buy-Sell Funding for an Owner-Manager
Jonas, 45, owns 100% of a successful HVAC company with 18 employees. His personal income is $240,000; the company has $1.1 million in cash and a $500,000 operating line. Jonas's key employee, Priya, 52, runs operations and has been with the company for 12 years. Jonas has a group disability plan covering 60% of salary to a maximum of $8,000/month, with a 90-day waiting period and a 24-month own-occupation definition. He also has a $500,000 term life policy personally, with his spouse as beneficiary. Jonas was recently diagnosed with Type 2 diabetes and hypertension, both controlled with medication. He wants to fund a buy-sell agreement with Priya and protect the company if either becomes disabled. Priya has no disability insurance. The company has no buy-sell agreement. Jonas's spouse is not involved in the business. He asks whether to use group coverage, individual disability insurance, or a corporate-owned policy.
1. Quantify Jonas's disability coverage gap and recommend an individual policy design.
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Jonas earns $240,000, or $20,000 per month. Group coverage at 60% would be $12,000 per month, but the plan caps benefits at $8,000, leaving a $4,000 monthly gap before tax. The group plan also changes from own-occupation to any-occupation after 24 months, which is a serious risk for a hands-on owner.
An individual policy should target $4,000 to $5,000 per month of additional benefit, with:
- Own-occupation definition to age 65.
- 90-day waiting period to match the group plan, unless savings allow a longer wait.
- Residual disability benefit and cost-of-living adjustment.
- Future-insurance option to increase coverage if income rises.
- Waiver of premium and renewable-to-age-65 terms.
Because of the diabetes and hypertension, the insurer may rate or exclude the condition. Jonas should disclose both diagnoses, provide recent A1C and blood-pressure readings, and keep the group plan in force. He should not cancel group coverage until the individual policy is issued and in force.
2. Design a buy-sell funding structure between Jonas and Priya, including the tax treatment to consider.
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Start with a valuation and a written buy-sell agreement that fixes the trigger events, valuation method, funding, and payment terms. The funding should include life insurance and disability buy-sell insurance.
Corporate-owned structure: the company owns policies on Jonas and Priya, pays the premiums, and receives the death benefit. Premiums are generally not deductible. On death, the death benefit creates a credit to the capital dividend account, and the company can pay the tax-free portion as a capital dividend. The company then purchases the shares. This is administratively simple, but it concentrates ownership and control in the company and requires a tax review.
Cross-purchase structure: each shareholder owns a policy on the other. Premiums are not deductible, and the death benefit is generally received tax-free by the surviving shareholder, who then buys the shares. This can be cleaner for basis but harder to administer with more shareholders.
For disability, a disability buy-sell policy can provide a lump sum to fund the purchase. Premiums are generally not deductible, and the tax treatment of benefits depends on the structure. The agreement should be reviewed by legal and tax advisers before implementation.
3. What underwriting and disclosure steps are required, and what happens if Jonas does not disclose his diagnoses?
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Jonas must answer all medical questions truthfully and disclose the Type 2 diabetes and hypertension, including medications, dates of diagnosis, A1C results, and blood-pressure readings. The insurer may request medical evidence or an attending physician's statement. Priya must also apply and disclose her own health history. The company should not rely on the group plan as a substitute for individual coverage.
If Jonas fails to disclose a material fact, the insurer may rescind the policy or deny a claim. In Canada, insurers generally have a two-year contestability period for material misrepresentation, but fraud can affect claims beyond that. Non-disclosure also creates professional and business risk: the buy-sell agreement may be unfunded when it is needed most. The adviser should document the disclosure discussion and keep copies of the application.