An Uninsurable Partner, an Overfunded Buy-Sell, and a Policy Transferred Twenty Months Ago
Two equal partners own an architectural firm. Partner A is 58 and owns 50%; Partner B is 45 and owns 50%. Their cross-purchase buy-sell values each interest at $2.4 million and is funded with $2.4 million of 20-year level term: B owns a policy on A's life, and A owns a policy on B's life. A was recently diagnosed with early-stage prostate cancer and is now uninsurable; his existing term is guaranteed renewable to age 70 at a steeply rising premium. Twenty months ago A transferred a $1.5 million whole life policy on his own life to an irrevocable life insurance trust, naming his wife as trustee; he continues to pay the premiums from the couple's joint checking account, and the trustee sends Crummey withdrawal notices. Neither partner has liquidity outside the business.
1. A is now uninsurable and his term coverage expires at 70. How should the buy-sell funding be restructured?
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First, protect what exists. The $2.4 million term policy on A is contractually guaranteed renewable - do not lapse it, do not miss a premium, and confirm the renewal premium schedule now. It is the only death benefit the arrangement will ever have on A.
Second, understand the real risk. The plan fails in the scenario where A outlives age 70 and then dies. In that case B must buy $2.4 million of stock with no insurance. The fix is a layered sinking fund: the firm or B sets aside a defined annual amount so that by year 12 the reserve plus remaining term coverage covers the obligation.
Third, consider the direction of the exposure. Under a cross-purchase, B pays A's estate tax-free proceeds and takes a stepped-up basis. If B dies first, A receives $2.4 million - which A no longer needs funded, since he is the one with the liquidity risk. Consider converting to a one-way arrangement: A drops or assigns the policy on B, and only B insures A.
Fourth, paper the shortfall. Amend the agreement to permit an installment note with a stated interest rate and a cash down payment (30% is a common benchmark), secured by the purchased shares. Without that clause, the estate can refuse a note and demand cash B does not have.
2. Analyze the ILIT: the three-year rule, the trustee choice, and the premium payments from joint funds.
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The three-year problem is live. A transfer of an existing policy to an ILIT is a gift, and if the insured dies within three years of the transfer, the entire death benefit is pulled back into his gross estate under Section 2035. He is 20 months in. If he dies before month 36, roughly $1.5 million is included and the estate tax exposure returns. Nothing can be done to shorten the clock; the only response is to plan the estate as though inclusion is possible and disclose the contingency to the trustee.
Trustee. A spouse who is a beneficiary and trustee is generally acceptable for this purpose, but any trustee power that lets the insured or his spouse benefit - loans, withdrawal rights, powers over beneficial enjoyment - risks Section 2042 incidents of ownership or a retained-interest argument. Review the instrument and strip discretionary powers from the insured entirely. A is not a trustee, which is correct; keep it that way.
Premiums. Paying from joint checking means the funds are presumptively one-half each spouse's. If A pays his half, he makes an annual-exclusion gift to the trust; the spouse's half must also be funded as her own gift through her own check or a separate account, or the gift is split on a timely filed gift tax return. Have each spouse write a separate check to the trustee rather than paying the insurer directly, and have the trustee pay the premium. Confirm Crummey notices go to all current beneficiaries, allow a reasonable window, and that no pre-arranged withdrawal understanding exists.
3. The partners want to convert the cross-purchase to a stock redemption plan funded by the existing policies. What transfer-for-value and redemption issues arise?
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Transfer for value. Section 101(a) generally makes death proceeds taxable as ordinary income when a life policy is transferred for consideration. There are four exceptions: a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. The partner-to-corporation transfer falls within the last exception - B transfers his policy on A to the corporation, and A is a shareholder of that corporation. Proceeds remain income tax free.
Do not structure it as a purchase by the corporation for a price, and do not route the transfer through a third party or a trust. Either move can land outside the exception. Document the transfer as a capital contribution of the policy, or a distribution and recontribution, and confirm fair market value under Section 79 interpleader rules if the corporation pays anything.
Other consequences:
- The corporation becomes owner and beneficiary; on A's death it receives proceeds and must redeem A's shares. That corporate receipt is generally not taxable income.
- The surviving shareholder gets no basis step-up from insurance proceeds. Basis increases only if the corporation redeems stock - and under Section 302 the redemption must qualify as a complete termination, substantially disproportionate, or a Section 303 redemption to avoid dividend treatment.
- Entity-owned policies count toward the corporation's value and the insured's estate under Section 2042 if the insured holds more than 50% of the corporation. With 50/50 ownership he does not, but the analysis must be redone if ownership shifts.
Recommendation: confirm the exception applies in writing before any transfer, and run the 302/303 analysis on the redemption.