Three Partners, One Buy-Sell, and Two Tax Landmines
Three physicians are equal partners in an Illinois professional partnership taxed as a partnership, each holding a one-third interest. The buy-sell agreement requires the partnership to redeem a deceased partner's interest at fair market value, currently $500,000 per partner. The partners are weighing financing with three $500,000 policies owned by and payable to the partnership, versus six $250,000 policies owned cross-purchase. Alan, the oldest at 61, also wants to reposition $400,000 of cash into a single-premium whole life policy for his children, and he plans next month to assign an existing $1,000,000 whole life policy he owns on his own life to an irrevocable life insurance trust for his grandchildren. He is in excellent health, has a taxable estate, and files jointly with his wife.
1. Compare the entity-purchase and cross-purchase designs on policy count, basis, estate inclusion, and deductibility.
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Policy count. Entity purchase needs 3 policies (one per partner). Cross-purchase needs 6 ($250,000 from each partner on each of the other two), and the number grows geometrically - ten partners would need 90.
Basis. This is the decisive economic difference. In a cross-purchase, the surviving partners buy the decedent's interest with their own money and receive a basis step-up equal to the purchase price, so a later sale of the practice produces less capital gain. In an entity redemption, the surviving partners' outside basis is unchanged; the partnership may make a Section 754 election to step up inside basis, but that requires an affirmative election and does not always fully solve the problem.
Estate inclusion. With an entity-owned policy, the death benefit increases the value of the practice, and the decedent's partnership interest - including a share of the proceeds - may be pulled into the gross estate even though the estate never receives the policy proceeds. A properly drafted buy-sell that fixes value under Section 2703 offsets this, but it is a drafting risk. Cross-purchase avoids the issue entirely.
Deductibility. Premiums are never deductible under either design. So are the proceeds excludable under Section 101(a) - and a partnership is not an 'employer' for Section 101(j) purposes. But if the practice later incorporates as an S corporation, Section 101(j) applies: employer-owned death benefits become taxable unless notice-and-consent rules are satisfied and an exception (such as the insured having been an employee within 12 months) applies.
Recommendation direction: with three healthy partners of similar age, cross-purchase is usually cleaner; with many partners or disparate ages, entity purchase plus a Section 754 election is the practical compromise.
2. Alan funds a $400,000 single-premium whole life policy for his children. What tax status results, and what changes for him?
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It fails the seven-pay test and becomes a modified endowment contract. Any policy funded more rapidly than seven level annual premiums produces a MEC. The death benefit is unaffected - it remains income-tax free to the children under Section 101(a) - but every living-benefit feature is degraded.
What he loses:
- Income-first taxation. Withdrawals and policy loans are taxed as income to the extent of gain before any basis is recovered. Under a non-MEC policy, loans are generally tax free while the policy is in force.
- Penalty exposure. A 10% additional tax applies to the taxable portion of a pre-death distribution before age 59 1/2. Alan is 61, so this penalty is not a concern for him personally.
- Ordering rules on assignment. Assigning a MEC to another person can itself trigger income recognition.
- Permanent taint. A 1035 exchange of a MEC into a new policy carries MEC status forward.
What he should weigh instead: if the goal is a tax-efficient transfer to the children, a limited-pay design that satisfies the seven-pay test, or an ILIT-owned policy funded over time, achieves the estate and income tax goals without the MEC taint. If he simply wants to move $400,000 of cash, a MEC is acceptable only when he is certain no withdrawal or loan will ever be needed - and at 61, with a taxable estate, liquidity needs are likely.
3. He assigns the existing $1,000,000 policy to the ILIT next month and dies two years later. What are the transfer tax consequences, and what should have been done differently?
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The Section 2035 three-year rule applies. If the insured transfers an existing policy and dies within three years of the transfer, the death benefit is included in his gross estate, exactly as if he had never made the gift. Dying at two years means the ILIT is disregarded for federal estate tax purposes and the $1,000,000 is taxed in his estate. Had the ILIT purchased a new policy on his life from inception, there would be no transfer and no three-year lookback - that is the standard fix, and it is why agents push new-issue ILITs for older clients.
Gift tax reporting. The assignment is a gift in the year made. Its value is not the face amount but roughly the interpolated terminal reserve plus unearned premium - for example, $140,000 on a $1,000,000 policy. Form 709 is due, and because a transfer to a trust for grandchildren is a future interest, the annual exclusion is unavailable unless the trust grants Crummey withdrawal rights, and the generation-skipping transfer tax must be allocated.
State tax. Illinois imposes its own estate tax with a $4 million exclusion and no portability, so the estate may owe Illinois tax even if no federal tax is due.
What to advise now: keep the policy in his name or use a new ILIT-issued policy; if the transfer proceeds, survive three years and keep premium gifts reported annually.