Disability Buyout Funding Gap in a Dental Practice
Two equal owners of a dental practice, ages 57 and 54, have a buy-sell agreement valuing the practice at $4 million. Each owns a $2 million disability buyout policy with a 365-day elimination period, a 24-month payout, and a 100% ownership trigger. The practice pays the premiums and deducts them. Dr. A also has group long-term disability paying 60% of salary up to $15,000/month, own-occupation for 24 months then any-occupation, offset by individual DI. Dr. A has $18,000/month individual DI with a 90-day wait. The buy-sell says a disabled owner must sell after 12 months of disability. Dr. B has only $500,000 of liquid capital and no bank commitment. Dr. A suffers a stroke and is expected to be out 18 months, possibly permanently.
1. Quantify the buy-sell funding gap and identify the timing and definition mismatches.
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Dr. A’s share is $2 million. The buyout policy face is $2 million, but because the practice deducts premiums, benefits may be taxable; at a 37% rate the net could be roughly $1.26 million. The policy pays over 24 months, not in a lump sum. Dr. B has only $500,000 liquid, so the cash gap is at least $1.5 million before tax and larger after tax. The buy-sell requires sale after 12 months, but the policy has a 365-day elimination period plus a 24-month payout, so the trigger and funding are misaligned. The 100% ownership trigger may not match the buy-sell’s 12-month disability definition. Group LTD is own-occupation for only 24 months and may offset the individual DI. Reconcile all definitions and funding sources before closing.
2. Explain the tax treatment of premiums and benefits for the buyout policy, group LTD, and individual DI.
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Buyout policy: if the practice pays and deducts premiums, the disabled owner generally includes benefits in income. If premiums are nondeductible to the owner, benefits are tax-free. Because the practice deducts, assume taxable unless ownership is changed. Group LTD: employer-paid premiums produce taxable benefits; any employee-paid portion produces tax-free benefits. Individual DI: premiums paid with after-tax dollars produce tax-free benefits. The buyout policy and group LTD may not offset each other unless the policy or buy-sell says so; group LTD may offset individual DI. Review policy language and W-2 treatment. Taxable buyout proceeds reduce net funding, so the face amount should be grossed up to deliver the needed after-tax purchase price.
3. Recommend fixes to the buy-sell agreement and the funding arrangement.
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Amend the buy-sell to align the definition of disability, the 12-month trigger, and the payout period. Consider changing ownership to cross-purchase policies with after-tax premiums so benefits are tax-free, or gross up the face amount if the practice continues to pay and deduct premiums. Increase the buyout face or add a sinking fund, term insurance, or a bank commitment. Because Dr. B has only $500,000, use a secured installment note with a reasonable interest rate, but recognize that Dr. A may need cash. Add a temporary management plan and a valuation update. Review whether the group LTD offset reduces the individual DI and whether the buyout policy coordinates with either policy. Fund both partners, not just Dr. A.