Partnership Agreement and Buy Out Insurance – What you wish you knew before your partner got disabled.

Well run firms take multiple steps to ensure the transition of leadership and revenues of the firm from the partners of today to the partners of the future.  It is commonly known that a Life Insurance Buy Out plan should be in place (in the partnership agreement and backed by insurance) for transition planning should a partner die pre-retirement. However, the far more likely to occur scenario for your firm (twice as likely) is the disability of one of your partners.  And ironically, while some firms have a Disability Buy Out Plan (in the partnership agreement), they do NOT have insurance backing up the promise.  They don’t have Disability Buy Out insurance.

When Disability Buy Out Insurance is effectively structured, the disabled partner is able to separate themselves from the firm with a fair buy out amount.  The firm alleviates the possibility of an untimely cash demand by the disabled partner.  And most importantly, everyone avoids a sticky situation of conflicting loyalties (firm and friends) that can sometimes lead to expensive litigation.

There are three key elements for your Disability Buy Out Strategy.  Each point should be addressed in your Partnership agreement and backed up by Disability Buy Out Insurance.

1)     Total Benefit: This number would be based on the market value of the firm and the percentage ownership of each partner. 

2)     Elimination Period: This is the length of time from when the partner becomes disabled until the policy will pay a benefit – in effect, it’s the policy’s deductible.  Most policies have an option of a 12, 18, or 24 month Elimination Period.  Most firms go with 18 months.  The strategy is to choose a long enough time to only be triggered when it becomes clear that the disabled partner will not be able to return to the firm.

3)     Pay Out Period: This can be a Lump Sum up to 5 years or some combination. The longer the pay out, the less expensive the policy.

The insurance premiums are not tax-deductible and any benefits paid to the company are free of income taxes. Funds paid to the disabled partner are taxed as a capital transaction, as the firm is buying their share out.

It is important that your insurance adviser has law firm partnership experience specifically to review your partnership agreement to make sure the promises and products are in sync.  Proper planning can plan for this unfortunate but common event.

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