(FORTUNE Small Business) – It's among a business owner's worst fears: an unexpected illness puts your company at risk, forcing the sale of assets or pushing a financial burden onto relatives or partners. A recent Harvard study found that about half of all bankruptcies in the U.S. are precipitated by medical bills--even though many of those who file for bankruptcy are covered by health insurance. The recent debates in Washington about restructuring Social Security and Medicare have put the issue into sharper focus, and many baby-boomers are taking a closer look at a poorly understood type of insurance: long-term-care coverage.

Until recently this relatively new type of policy--which covers nursing-home care, assisted living, or home health care--was one that many small-business owners dismissed as an unnecessary luxury. But as more sophisticated products enter the market, entrepreneurs are using them to augment basic disability insurance. More appealing, the policies can be a great financial-planning tool--a way to transfer money out of a successful business without incurring tax bills.

As you probably know, premiums for long-term-care insurance are deductible as a business expense--fully deductible for a C-corporation; partially deductible, according to your age, for an S-corp. But you may not realize that the benefits paid out are tax-free as well, up to $240 a day in 2005. (As FSB went to press, the 2006 amount had not been announced.) "There's nothing else that I can think of where the company gets the deduction, and when the individuals start collecting the benefits, they still don't pay tax," says Cynthia Turoski, an accountant and financial planner at DR Financial Services of Colonie, N.Y.

Unlike virtually all other employee benefits, including basic health insurance, long-term-care insurance is not subject to nondiscrimination rules under the Employee Retirement Income Security Act of 1974 (ERISA). You can buy the coverage just for yourself, a spouse who is on the payroll, or selected executives who are key to your business.

The policies offer many options--for example, cost-of-living adjustments, which can help you maximize the tax deduction. Another payment arrangement, known as "ten-pay," means you can pay for the policy during your ten consecutive highest-earning years, when you most need the tax deduction. "What people are doing now is buying really rich policies to deduct the maximum from the corporate checkbook," says Marilee Driscoll, author of The Complete Idiot's Guide to Long-Term Care Planning. Harley Gordon, a lawyer and author of How to Protect Your Life Savings From Catastrophic Illness, agrees. "For example," Gordon says, "my long-term-care insurance costs $2,400 a year. For my age the most I can deduct is $1,200. In my tax bracket that's worth $300. But if my wife is an employee and I buy her a ten-pay, my business can deduct the whole thing."

Long-term-care insurance can also act as a substitute for disability insurance. Dr. Jim English, 51, a plastic surgeon in Little Rock, wanted to increase disability coverage for himself and a few key employees. But he had maxed out on the amount that he could qualify for, based on his income and his profession as a doctor. (A common problem encountered by business owners in certain industries is that insurers cap the amount they'll underwrite for businesses they consider riskier, such as medical and dental practices, or for cash-based businesses such as restaurants or convenience stores.) English's agent at Northwestern Mutual, Calvin Diggers, suggested that he purchase long-term-care insurance instead. "Even a business owner who brings in quite a bit of revenue may not have enough net income to buy much disability, especially if he is putting profits back into the business," says Diggers. "Long-term-care insurance has recently been viewed as a good solution." As an added advantage, long-term-care insurance covers you for life, while disability typically ends at 65, an age when many business owners are still working.

After getting the go-ahead from his accountant, English purchased the insurance, opting for cash-benefit policies. These newer policies pay out a set dollar amount, say $150 or $200 a day, as opposed to reimbursing the policyholder for the amount he actually spends on care. Cash-benefit policies are increasingly available--New York Life, Prudential, and State Farm offer them, as do the three companies in the table above--and they provide more flexibility than earlier products. Once the benefit is triggered, the insurance company cuts you a check for the sum, and you have no obligation to show how you're spending it. One caveat: The money remains tax-free only if it is spent on care. Otherwise it is taxed as income.

CARRIERS WITH HEFT

Choose a long-term-care policy from a leading provider that is known for financial strength. Here are the top three sellers.

SOURCE: Broker World, July 2005, "2005 Survey of Long Term Care Insurance Industry," co-sponsored by Tillinghast of Towers Perrin and Society of Actuaries. Ratings by A.M. Best. NOTE: Premium revenue from policies sold in 2004.