The Business Owner's Buy-Sell and the Uninsurable Partner
Ravi and Tom are 50/50 owners of a specialty fabrication company valued at $3.2 million. Their buy-sell agreement is a cross-purchase funded by $1.6 million of term life insurance on each owner. Ravi, 54, was recently diagnosed with Type 2 diabetes with complications and elevated liver enzymes; his last application for additional coverage was declined. Tom, 51, is in excellent health. The company has a $900,000 term loan personally guaranteed by both owners. Ravi is married with two children in college; Tom is single. The agreement says nothing about disability, and neither owner has individual disability coverage. Ravi wants to retire at 60 and expects the company to buy him out.
1. What funding and structural gaps exist in the buy-sell arrangement, and how should they be addressed given Ravi's insurability?
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Several gaps compound:
- Valuation staleness: $3.2 million is a point-in-time number. The agreement needs a defined valuation method (independent appraisal every three years, or a formula) and a funding-review trigger.
- Funding mismatch: $1.6 million per owner assumes the valuation holds. If the business grows, the policies underfund the obligation. More critically, Ravi's decline means no additional coverage can be purchased on his life to keep pace.
- Insurability risk: With Ravi declined, the cross-purchase structure depends entirely on Tom's policy to buy Ravi's shares at death - that part works. But Ravi's policy on Tom is the one that funds Tom's premature death; if Ravi dies first, Tom must buy Ravi's shares, and Tom's policy is in force, so that leg is covered. The real exposure is Ravi outliving the arrangement or becoming disabled.
- Alternatives for the uninsurable partner: use a sinking fund or company-owned reserve, a partial self-funding schedule, an installment-note buyout at death, or a combination. Consider whether the entity should own policies (stock redemption) versus cross-purchase - a redemption creates basis and corporate AMT/accumulated earnings issues and leaves surviving shareholders with a basis step-up problem, so review with the CPA.
- Personal guarantee: the $900,000 loan guarantee means Ravi's estate could be pursued if the business fails after his death. Review whether the guarantee can be released or collateralized.
Recommend a written amendment, an updated appraisal, and a funded disability provision.
2. Ravi has no disability coverage and a stated retirement age of 60. How would you frame the disability and exit-planning risk, and what would you recommend?
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Disability is the largest unaddressed risk. For a 54-year-old with diabetes complications, the probability of a disabling event before 60 is materially higher than mortality, and a disability would simultaneously stop his income, trigger the personal guarantee exposure, and leave the buy-sell silent - there is no obligation for Tom to buy him out, and no money to do it if there were.
Frame it in three layers:
- Income protection: individual disability income insurance, if available at all, will likely be rated or excluded for diabetes-related causes. Pursue it anyway with an occupation-specific 'own occupation' definition and a benefit period to 65; if declined, explore group or association coverage, or a graded-benefit policy. Where insurance is unavailable, build a self-funded disability reserve inside the business.
- Buy-sell disability clause: add a disability trigger with a defined waiting period (e.g., 12 months of inability to perform material duties), a valuation method, and a funding source - either a disability buy-out policy (if insurable) or an installment note funded by company cash flow.
- Exit planning: Ravi's plan to be bought out at 60 requires Tom to have liquidity or financing. Model whether company cash flow can support a $1.6 million note over, say, 7–10 years while servicing the $900,000 term loan. If not, the timeline is aspirational, not funded.
Recommend a written exit timeline, a funded reserve, and a documented succession plan, and coordinate with the CPA and attorney.