Entity Buy-Sell, a Rated Owner, and Employer-Owned Life Insurance
A three-physician group, equal one-third shareholders, has an entity-purchase buy-sell agreement. Each owner is insured under a $1,000,000 15-year term policy owned by and payable to the professional corporation, which deducts the premiums. The agreement prices each share at the greater of book value or $900,000 and gives the corporation 90 days to pay after a triggering event. Dr. Patel, 61, just had a stent placed; his renewal is now rated Table 4. His term policy was issued at age 56, is convertible to age 65, and expires at 71. He plans to retire at 66. The other two owners want to cancel his coverage to avoid the rated premium and start a sinking fund instead. Book value is currently $640,000 per share.
1. If the corporation cancels Patel's term policy and buys a new one at the rated premium, is the $1,000,000 death benefit still income-tax-free?
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Two separate rules apply - do not stop at the first one.
1. Transfer-for-value (§101(a)(2)) A policy transferred for valuable consideration loses the income-tax exclusion, but the exceptions include a transfer to the insured, a partner of the insured, a partnership in which the insured is a partner, and a corporation in which the insured is a shareholder or officer. An entity-held policy on a shareholder-officer therefore fits an exception, and a brand-new policy is not a transfer at all. So this rule does not sink the plan.
2. Employer-owned life insurance (§101(j)) Because the corporation owns the policy, pays the premium, and is the beneficiary, this is an EOLI contract. Unless the employer gave written notice and obtained the employee's written consent before issue (and the insured was a highly compensated employee at issue), the exclusion is capped at premiums paid - the remaining death benefit is taxable to the corporation. A new policy issued at 61 is a new contract, so a fresh notice and consent is required.
The bigger practical objection to cancelling
- Conversion to age 65 requires no new evidence of insurability; a new policy at Table 4 does. If he is declined, the buy-sell is unfunded.
- A new policy restarts the two-year contestability period and a new suicide clause.
- Cancelling coverage an owner is obligated to maintain under the agreement may itself breach the agreement.
Recommendation: convert a portion of the existing term (locked-in class) rather than replace it, and audit the notice-and-consent file.
2. Evaluate the other owners' sinking-fund proposal against the actual obligation the agreement creates.
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Do the arithmetic before agreeing to anything.
- Premium on $1,000,000 of term at 61, Table 4, is on the order of $10,000–$14,000 a year - call it roughly $12,000. The sinking fund the owners propose requires setting aside $900,000 over about five years ≈ $180,000 a year, paid with after-tax corporate dollars (premiums are not deductible; neither are sinking-fund deposits).
- They are proposing to trade about $12,000 a year of leverage for $180,000 a year of cash drag, and a dollar of death benefit buys about $1.00 of buyout while a dollar of term premium buys about $80 of death benefit at these ages.
Where the funding genuinely fails
- Lifetime retirement at 66. The policy pays nothing; the corporation still owes the greater of book value or $900,000, in cash, within 90 days. That is the real unfunded event, and no term policy ever solves it.
- Book value growth. Book value is $640,000 and rising; if it passes $1,000,000, the death benefit no longer covers the price.
- The 71 expiry is irrelevant if the agreement forces a buyout at 66 - but only if the agreement actually has a mandatory retirement trigger. Confirm that language.
Better structure Keep the term (cheap leverage for the premature-death risk), fund the retirement buyout with a defined payout schedule over five to ten years instead of 90 days, and consider a small permanent policy or paid-up additions on Patel to cover the post-65 tail. If the rated premium truly hurts, reduce the death benefit to the current $900,000 obligation rather than cancel.
3. The group is also considering switching from an entity purchase to a cross-purchase. What changes, and what else should be fixed in the agreement?
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Entity vs. cross-purchase
- Policy count: entity purchase = 3 policies; cross-purchase with 3 owners = 6 policies. Cross-purchase becomes unwieldy as owners are added.
- Basis step-up: this is the decisive difference. In an entity redemption, the corporation takes the shares with a carryover basis and the surviving shareholders get no increase in basis - they later sell with more gain. In a cross-purchase, each survivor gets a basis equal to the price paid, reducing future capital gain.
- Creditor and control exposure: under an entity purchase the policies sit on the corporation's balance sheet and are reachable by corporate creditors; under a cross-purchase they are exposed to each owner's personal creditors.
- §101(j): employer-owned status disappears under a cross-purchase, so notice and consent are no longer an issue.
- Funding: entity purchase is funded with corporate dollars (not deductible); cross-purchase is funded with personal after-tax dollars unless the practice bonuses the premium (then taxable to the owner but deductible to the practice).
Other fixes for this agreement
- Confirm the trigger list explicitly includes retirement, disability, divorce, and attempted sale to an outsider - otherwise the buyout is optional and the funding analysis collapses.
- Lengthen the 90-day cash requirement or allow a promissory note with a stated interest rate and security.
- Reconcile the price formula: the greater-of test means the $1,000,000 face can become inadequate as book value grows; index the face or add a periodic review clause.
- Verify notice-and-consent documentation now, before any claim.