Funding a Three-Owner Buy-Sell When One Owner Is Uninsurable

The obligation is the same either way: $600,000 per deceased member.

Entity redemption. The LLC owns one policy on each member:

• 3 policies × $600,000 = $1,800,000 of face.
• The LLC receives the proceeds and purchases the interest from the estate.

Cross-purchase. Each surviving member must buy the deceased's 1/3 interest. Two survivors splitting $600,000 means each needs $300,000 of coverage on each of the other two:

• 6 policies × $300,000 = $1,800,000 of face.

The common error is to buy $600,000 per member in a cross-purchase, which overfunds the obligation twofold and produces a windfall the agreement never contemplated. The face amounts must be derived from how much of the decedent's interest each buyer is obligated to purchase, not from the appraised value alone.

Underwriting is the binding constraint. In an entity design, the LLC needs $600,000 on Cal alone. If he is declined, the LLC holds $1,200,000 on the two healthy members and has zero funding for the death most likely to occur first - a structural failure, not a pricing problem. In a cross-purchase, Ana and Ben each need $300,000 on Cal, which is a smaller ask but still subject to the same impairment.

Salvaging Cal's existing policy. Transferring it is viable: the transfer-for-value rule taxes death proceeds when a policy is transferred for consideration, but the statute excepts transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, and to a corporation in which the insured is a shareholder or officer. So Cal's policy can move to the LLC or to Ana and Ben, and the $600,000 death benefit stays income tax free.

The trap. A transfer to anyone outside those categories - a revocable trust that is not itself a partner, or a buyer brought in later - destroys the exclusion, and the beneficiary would owe ordinary income on proceeds above the $14,000 basis. Also, transferring a policy does not cure underwriting: the carrier keeps the original contestability and suicide periods running from the original issue date, which on a policy issued 15 years ago means they have long expired.

To the LLC. The $600,000 is received income tax free, but premiums paid were never deductible and the proceeds increase the value of the partnership before the redemption reduces it. The proceeds are not automatically "free money" to the survivors.

To Cal's estate. The estate recognizes gain on the redemption to the extent the $600,000 exceeds Cal's outside basis in his interest. Payments can also be split: amounts attributable to the interest are capital under section 736(b), while amounts for goodwill or unrealized receivables can be ordinary income to the estate under 736(a) unless the agreement specifies otherwise.

To Ana and Ben. In a redemption, they receive no basis step-up in the interest they now hold, even though the LLC spent $600,000. That is the single biggest hidden cost of the entity design in an appreciating business.

Cross-purchase alternative. Ana and Ben each pay $300,000 directly and each takes a stepped-up basis in the portion acquired, reducing future gain on sale. The trade-offs are administrative: six policies, differing ages and premiums, and a premium-sharing formula that allocates the largest cost to the youngest owner. Given Cal's impairment, the practical answer is a hybrid - use Cal's existing $600,000 policy to fund his side of a cross-purchase, and shift the healthy lives to the structure that preserves basis.