Buy-Sell Funding at Ages 58 and 61
Two owners of a commercial HVAC company, ages 58 and 61, have a cross-purchase buy-sell agreement. The business is valued at $2.4 million; each owner is to be insured for $1.2 million to fund the purchase of the other's interest. The older owner has controlled hypertension and a family history of heart disease. Their agent recommends replacing each owner's existing $500,000 whole life policy with a new universal life policy that has a no-lapse guarantee. The new policy would be funded by a 1035 exchange of the whole life cash value-$210,000-into a policy with a $1.2 million death benefit. The agent projects that the new policy will require $38,000 annual premium for 10 years, then stop, but the illustration assumes a 6.5% crediting rate. The older owner's existing policy has a $310,000 cash value and a $500,000 death benefit. The buy-sell agreement requires the policies to be owned by each owner on the other, but the current policies are owned by the business. The wife of the older owner is the current beneficiary.
1. Evaluate the suitability of replacing the existing whole life policies with the proposed universal life policies for the buy-sell funding.
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The buy-sell need is $1.2 million per owner, so the existing $500,000 policies are insufficient. But the solution is not automatically replacement. The older owner's controlled hypertension and family history may produce a rated offer or a decline at his age, and replacing existing coverage could put the $500,000 already in force at risk. The proposed universal life relies on a 6.5% crediting assumption; if crediting is lower, the $38,000 premium for 10 years may not support the no-lapse guarantee, and the policy could lapse exactly when the buy-sell needs it. The agent should compare the guaranteed column, not the illustrated column, and stress-test at the guaranteed minimum rate. A better approach may be to keep the existing whole life policies and add guaranteed term or a guaranteed universal life policy for the $700,000 gap. Replacement is suitable only if the new policy is clearly better on a guaranteed basis and the older owner is insurable at an acceptable rating.
2. What ownership and beneficiary problems exist, and how should they be corrected to match the cross-purchase agreement?
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The buy-sell is a cross-purchase agreement: each owner should own a policy on the other owner and be the beneficiary of that policy. The current policies are owned by the business, which makes them entity-owned or redemption-plan assets, not cross-purchase assets. That mismatch can cause income-tax and estate problems and may not fund the agreement as written. The wife as beneficiary is also inconsistent with the cross-purchase design; if the older owner dies, the wife would receive the death benefit instead of the surviving owner using it to buy the interest. The agent should coordinate with the clients' attorney and tax adviser to change ownership and beneficiary designations to match the agreement. The insurer must approve any ownership change, and the agent should consider transfer-for-value rules, gift-tax issues, and whether the business should instead adopt a stock-redemption plan. No ownership change should be made without legal and tax review.
3. Explain the MEC and illustration risks in the 1035 exchange and recommend alternatives.
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A 1035 exchange of $210,000 into a $1.2 million universal life policy can create a modified endowment contract if the policy fails the 7-pay test. A MEC still allows tax-deferred growth, but loans and withdrawals are taxed income-first and may incur a 10% penalty before age 59½. That reduces the policy's flexibility if the owners need cash for premiums or the buy-sell. The illustration is also a risk: projected premiums based on 6.5% crediting are not guaranteed, and a policy that is overfunded to reach the no-lapse guarantee may become a MEC. The agent should show the guaranteed minimum premium, the guaranteed death benefit, and a lapse scenario. Alternatives include keeping the existing whole life policies and adding guaranteed term or GUL coverage for the difference, or using a carefully designed guaranteed universal life policy with a premium cushion. The client should sign an illustration acknowledgment and understand that the projection is not a promise.