Business Overhead Expense Insurance

Business overhead expense insurance is a form of individual disability insurance under which the insurer reimburses a business's continuing operating expenses during a period when its owner is disabled. The National Association of Insurance Commissioners describes it as covering "standard business expenses such as payroll, utilities, rent, etc., while the business owner recovers from a disability," and adds the point that defines the product: "note that most overhead insurance does not cover the business owner's salary."

It is a regulated product category rather than an informal package. New York's Department of Financial Services files it under the individual disability income provisions of Regulation 62 (11 NYCRR 52), and explains that "since the purpose of a business overhead expense policy is to replace income and revenues lost due to disability which are used to pay overhead expenses, the Department does permit product names such as 'Disability Overhead Expense Policy' or 'Business Overhead Expense Policy'." It can be bought as a standalone policy or, as the NAIC notes for very small firms, added as "a business overhead insurance rider, or amendment to a personal disability policy."

Two policies, two payees, and an owner-operator usually needs both. Personal disability insurance pays the disabled individual a stated monthly benefit to replace their income. Business overhead expense insurance pays the business, and only for expenses it has actually incurred. A solo dentist who breaks a wrist has two simultaneous problems: her household still has a mortgage, and her practice still has rent, a hygienist's wages, equipment leases and a phone line. The two products address one problem each, and neither substitutes for the other.

It reimburses rather than indemnifies, and that changes the shape of the benefit. New York's product outline describes the standard structure as one in which "covered overhead expenses actually incurred for each month are reimbursed for each month of total disability," subject to "a maximum monthly benefit each month and to an overall reimbursement level determined by a maximum benefit period expressed in time or a cumulative maximum monthly overhead expense benefit expressed in dollar terms." So a business whose expenses run below the monthly maximum receives less than the maximum, and many policies allow the unused amount to carry forward within the overall cap. That is the opposite of a personal disability policy, which pays its stated benefit whether the insured's actual expenses are high or low.

What counts as a covered expense, and the exclusion at the center of it. The categories are the fixed costs of keeping the doors open: rent or mortgage interest on business premises, utilities, telephone and internet, employee wages and payroll taxes, property and liability insurance premiums, equipment leases, professional dues, accounting and legal fees, and depreciation. The IRS revenue ruling that established the tax treatment of these policies describes the same list and states the exclusion in the same breath: covered expenses "shall include rent, electricity, heat, water, laundry, depreciation, employees' salaries and such other fixed expenses as are normal and customary in the conduct and operation of the insured's office but shall not include salary, fees, drawing account or any other remuneration for the insured or any other member of the insured's profession hired by or working with the insured." The owner's replacement is generally not covered either, which is a point owners are surprised by: hiring a locum to keep the practice running is often the first thing they want to do and often the thing the policy will not pay for. Whether a policy covers a substitute professional is a term to check before buying.

The benefit period is short on purpose. New York's filing standards give a sense of the range it will approve: an elimination or waiting period "of reasonable duration chosen by an insured (generally no longer than 6 months)" before benefits begin, and a maximum benefit period of which the Department says "generally, a maximum benefit period of at least one year would be considered reasonable." Those are that Department's own standards for approving a form rather than a description of the national market, but they reflect what the product is for. It buys time to recover, to bring in a partner, or to wind down or sell in an orderly way. It is not a substitute for long-term disability coverage on the owner personally, which can run to age 65 or beyond.

The tax treatment is the mirror image of personal disability insurance, and the IRS puts both rules on facing pages. Publication 334, the Tax Guide for Small Business, lists among deductible business insurance premiums "overhead insurance that pays for business overhead expenses you have during long periods of disability caused by your injury or sickness." Its list of non-deductible premiums includes, at item 2, "loss of earnings. You can't deduct premiums for a policy that pays for your lost earnings due to sickness or disability. However, see item 8 in the previous list." The cross-reference is the IRS pointing from one product to the other: personal disability premiums are not deductible, overhead expense premiums are.

The consequence on the benefit side follows from the deduction. Revenue Ruling 55-264 holds that proceeds from an overhead expense disability policy are includible in gross income under section 61 and that the premiums are deductible under section 162, reasoning that such policies "are issued strictly for business purposes and in no way compensate the insured for injuries or sickness." So the benefits are taxable to the business. In practice the effect is usually close to neutral, because the expenses the benefit is reimbursing are themselves deductible business expenses in the same period, and the two largely offset. The point to take from it is that the benefit is not a tax-free windfall and should not be budgeted as one.

Where it does not overlap. Business interruption insurance pays only when a covered property loss shuts the business down, so a disabled owner triggers nothing under it. Group disability coverage pays employees, not the business. And a buy-sell arrangement funded with disability insurance buys out a permanently disabled owner's interest, which is a different event with a different payee.

1. The owner documents the practice's fixed monthly expenses and buys a monthly maximum sized to them, since the policy reimburses actual expenses up to that ceiling rather than paying a flat sum.
2. A disability occurs and the owner satisfies the policy's definition of disability and its elimination period.
3. The business submits its actual covered expenses each month.
4. The insurer reimburses those expenses up to the monthly maximum, until the maximum benefit period or cumulative dollar cap is reached. Unused monthly amounts may carry forward within the overall cap where the policy provides for it.
5. The business reports the reimbursement as income and deducts the expenses it paid, which largely offset one another.

A hypothetical shows the reimbursement mechanic. Dr. Okafor's practice carries a policy with a $12,000 monthly maximum, a 90-day elimination period and an 18-month benefit period. She is disabled for seven months.

• The first three months fall inside the elimination period, so no benefit is paid. The practice's expenses in that window come out of its own reserves.
• In months four through seven her covered expenses run $9,500, $12,800, $10,200 and $9,000.
• The insurer reimburses the lesser of actual expenses and the $12,000 cap each month: $9,500 + $12,000 + $10,200 + $9,000 = $40,700. The $800 by which month five exceeded the cap is the practice's own cost.
• Her own compensation is not among the covered expenses in any of those months. That is what her personal disability policy is for.
• The $40,700 is taxable income to the practice, and the $41,500 of expenses it actually paid over those four months is deductible, so the net tax effect is small.

These are hypothetical figures illustrating the mechanics; policy limits, elimination periods and covered-expense definitions vary and are set by the contract.

Pros

• Keeps a small practice or firm operating through a disability, which preserves the enterprise value the owner would otherwise lose entirely.
• Protects the employees, since payroll is a covered expense and staff who are laid off during a closure rarely come back.
• Premiums are deductible as a business expense under the treatment set out in IRS Publication 334, unlike personal disability premiums.
• Reimbursing actual expenses means the business is not paying for coverage of costs it does not have.
• Available as a rider on a personal disability policy for very small firms, which the NAIC notes as an option for one- or two-person companies.

Cons

• The owner's own compensation is normally excluded, so this policy alone leaves the household unprotected.
• Benefit periods are short relative to personal disability coverage, so a permanent disability exhausts it long before the owner's working life would have ended.
• Benefits are taxable income to the business under the treatment of Revenue Ruling 55-264, which surprises owners who expect insurance proceeds to be tax-free.
• Because it reimburses actual expenses up to a cap, a business whose costs exceed the monthly maximum absorbs the difference itself.
• Whether a substitute professional's fees are covered varies by contract, and that is often the expense an owner most wants paid.
• It does nothing for a business whose revenue depends on an employee rather than the owner, which is what key person coverage addresses.