Three Owners, One Heart Attack, and an Unfunded Buy-Sell

Entity redemption (LLC buys the interest).

• One policy per owner, owned by and payable to the LLC; fewer policies and simpler administration.
• Premiums are not deductible, and the LLC needs the cash flow to pay them.
• The survivors receive no basis increase for the redeemed interest, so a later asset sale produces gain on the full value; the deceased owner's estate does get a step-up under §1014.
• Because the entity is a partnership, the agreement must specify that all payments are made for the interest itself under §736(b) - otherwise payments for goodwill and unrealized receivables can be taxed to the estate as ordinary income.
• The redemption must be required to reallocate the capital accounts in the agreement, or the surviving owners' percentages shift unintentionally without a corresponding capital adjustment.

Cross-purchase (owners buy the interest).

• Each survivor owns a policy on each other survivor: six policies here. Teresa buys 40/75 × $1.15M ≈ $613,000 on Ray; Owen buys 35/75 × $1.15M ≈ $537,000.
• Survivors get a full basis step-up equal to the purchase price, which is a large advantage on a later sale.
• Costs more to administer and requires each buyer to be underwritten and to have cash on hand.

Recommendation. For three owners with stable percentages and $6.2M of revenue, an entity redemption with an explicit §736(b) clause is operationally simplest, but the basis result favors a cross-purchase or a hybrid. A common compromise is a trusteed cross-purchase: a trustee holds and administers the policies, keeping the step-up while centralizing paperwork. A 'wait-and-see' buy-sell - entity option first, survivors second - preserves flexibility at the cost of certainty. Any transfer of existing policies between the partners or to the LLC should be checked against the transfer-for-value rule; the partner and partnership exceptions under §101(a)(2)(B) preserve the income-tax-free death benefit, but transfers to a non-partner (such as Carol) do not.

Underwriting reality. A myocardial infarction 14 months ago with two stents, diabetes at 7.8, and current smoking will produce a heavy table rating (commonly Table 6–10) plus possible flat extras at some carriers, and a declination at others. Shop the impaired-risk market, submit the cardiology records, the most recent A1c, and a quit date if there is one, and get informal quotes before promising anything. Ray should be told plainly that the eventual offer may be expensive or unavailable.

Product. The coverage must survive to and past 65, because Ray intends to retire then and the payout may be an installment note. That argues for:

• A guaranteed universal life contract with a lifetime no-lapse guarantee, or a whole life policy, sized to the projected buyout value; and
• A term policy to 65 layered on top to keep cost down during the working years, with a conversion privilege exercised before the term expires.

Reject any guaranteed-issue or simplified-issue product with a two-year graded death benefit: if Ray dies in the grading period, the payout is premiums plus interest, and the buyout is unfunded exactly when it is triggered. Graded benefits defeat the purpose of a funding policy.

Bridge the gap. The existing $500,000 of personal term is a stopgap only. Until the permanent policy is issued and past contestability, the operating agreement should contain an installment-payment provision so the LLC is not forced to borrow or liquidate. Do not let the buyout obligation depend on underwriting that has not been completed.

Other exposures. Add a disability buy-out trigger - Ray's disability risk is at least as high as his mortality risk and is currently unfunded - and consider key-person coverage if his production is material. Build in an increase option or periodic review, because a $1.15M obligation today may be $1.8M in a decade.

1. The funding gap itself. The agreement creates a 12-month obligation with no money behind it. Sign an interim installment-payout provision now, before underwriting is complete.

2. Ownership and insurable interest. Policies must be owned by the entity or the purchasing partners, with a written agreement stating who pays premiums and who receives proceeds. If the LLC pays premiums on a policy owned by Ray or his family without a documented split-dollar or compensation arrangement, the payments can be treated as taxable distributions or loans. Insurable interest is satisfied by the business relationship but must exist at inception.

3. Valuation discipline. The $4.6M appraisal has a date. The buy-sell should define fair market value with a formula or appraisal mechanism, set a review cadence, and resolve deadlocks - otherwise the funding and the obligation drift apart.

4. Teresa's divorce. The operating agreement should require spousal consent and bind each spouse to the buy-sell, so a marital dissolution cannot force a sale or create an outside owner. Confirm how her interest and its appreciation are characterized and that the buy-sell restriction is disclosed in the marital settlement.

5. Carol's position. She is an employee with no ownership and no rights on Ray's death; her employment terms should be documented separately so the business is not surprised.

6. Unfunded triggers. Retirement at 65 and long-term disability are both live risks with no funding. Address them with permanent coverage, a sinking fund, or a written installment schedule.

7. Documents. Coordinate beneficiary designations, a durable power of attorney permitting the buyout to be executed if an owner is incapacitated, and the estate plans of all three owners. Revisit annually.