Consider these numbers from the National Association of Insurance Commissioners and the Unum Provident Corporation. A firm with two partners, both age 35, risks a 67 percent chance that one of those partners will suffer a disability of three months or longer before reaching age 65 -- far higher than the odds of one of the partners dying before 65. Three partners age 45 run a 90 percent chance of disability. Despite these numbers, only 17 percent of the nation's small-business firms (100 employees or fewer) have disability coverage on a partner or key employees, according to an insurance-industry research organization, LIMRA.

A disability provision in a buy/sell agreement may not be necessary for a partner who is not active in the business, but the loss of an active partner to a long-term disability could prove devastating to the firm. Not only will the firm need to continue to provide income to the nonproductive person, but the disabled person won't be generating income for the firm. Eventually, the firm will want to replace the inactive owner, while the disabled person will want to recover his or her capital investment.

Consequently, any business planning a buy/sell agreement will need to consider a number of key questions: how long should the firm go without the active participation of a particular partner before buying out the partner; how will such a buyout be funded; and how can the firm pay the inactive owner in the meantime?

A firm could try to pay continuing salary and a buyout through current cash flow, profits and dividends, or a sinking fund, but this will prove too expensive for many firms. A loan is another option, but that is expensive and lenders may be reluctant to lend with a key partner out of the picture. Typically, the best choice is disability buyout insurance. This insurance is different from standard income-replacement insurance (which each owner and key employees should have) in that it is designed to buy out the ownership interests of the disabled partner at a pre-determined price.

A buyout disability policy pays out either in a lump sum or over a period of years (two to five is common), or a combination. Most policies require a waiting period of 12 to 24 months in order to adequately determine that the disabled person will not be able to return, and to prevent healthy owners from prematurely pushing the disabled partner out the door. Choosing a longer waiting period and installment payments will lower premium costs.

As with other types of buy/sell agreements, disability coverage will either be a cross-purchase, in which each owner individually buys coverage on the other owners, or redemption, in which the business itself buys the coverage. The tax consequences vary depending on the arrangement. For example, the premiums paid for a cross-purchase agreement are not tax deductible, but then the proceeds are not taxable, either.

Because of the tax consequences and the complexity of the buy/sell agreements, you'll want to work with a team of advisors: your financial planner, an insurance specialist, and an attorney, all of who need to be knowledgeable about buy/sells. Regardless of whether you use insurance or self-fund a buy/sell agreement, you'll need to determine the conditions for a disability buyout, ranging from the price of the buyout, what constitutes a disability and how long the disability can last before the buyout is triggered. One advantage of using insurance is that the policy defines what constitutes a disability (buy/sell agreements are often vague) and the insurance carrier is the one who determines whether the person meets that disability definition.