Funding a Buy-Sell When One Policy Sits Inside an Irrevocable Trust
Drs. Patel and Okafor are 50/50 owners of a two-dentist practice appraised at $2.4 million. Each wants a funded buy-sell agreement paying $1.2 million for a departing owner's shares. Both are 56 and in good health. Each owns a personal $1 million, 20-year level term policy issued when he was 42, so the term expires at 62 and the conversion privilege ends at 65. Patel separately owns a $400,000 whole life policy purchased eight years ago that is owned by an irrevocable life insurance trust naming his two children as beneficiaries. The trust has paid premiums from annual gifts, and no gift tax returns have ever been filed. Okafor proposes that the partners simply buy each other's term policies to avoid new underwriting, and that Patel's trust-owned policy be 'assigned into the buy-sell' since it already holds cash value. Their attorney asks for your written analysis before the agreement is drafted.
1. Compare an entity-redemption buy-sell with a cross-purchase agreement for this two-owner practice, and recommend one. Address policy ownership, premium funding, and the survivor's basis.
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With only two owners, the choice turns on three things: who owns the policies, what basis the survivor gets, and how premiums are taxed.
Entity redemption (the practice buys the shares): one policy owned by the practice, one premium payer, and simple administration if owners change. But the surviving owner receives no step-up in basis on the shares he already holds, and a redemption can be taxed as a dividend to the extent of corporate earnings and profits. Premiums are not deductible to the practice.
Cross-purchase (each owner buys a policy on the other): two policies, two premium payers using after-tax dollars. At the first death the survivor buys the shares and takes a stepped-up basis under IRC 1014, so a later sale of the practice produces less capital gain. Ownership also stays outside the practice, which matters if the practice is later sold to a third party or reorganized.
Recommendation: cross-purchase, or a trusteed cross-purchase arrangement to avoid two policies per owner if a third owner is added. Because the existing term policies expire at 62 - only six years away - new coverage to at least age 65-67 is needed. Use the conversion privilege only if the converted policy outperforms a freshly underwritten policy, which is likely at their ages and apparent health.
2. Okafor wants to buy Patel's term policy and Patel wants to buy Okafor's. Analyze the transfer-for-value rule and whether the death benefit would become taxable.
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Section 101(a) makes life insurance death benefits income-tax free, but 101(a)(2) removes that exclusion when a policy is transferred for a valuable consideration - cash, a promise to pay premiums, or a binding buy-sell obligation. A transfer-for-value makes the death benefit ordinary income to the recipient to the extent it exceeds the buyer's basis plus premiums paid.
There are statutory exceptions: 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. A partner-to-partner sale such as Okafor proposes fits the 'partner of the insured' exception, so the proceeds would still be received income tax free. The same exception would cover a sale into a partnership buy-sell but not into a corporation.
So the transfer-for-value rule is not the obstacle here. The practical obstacles are: (1) the policies have only six years of term left, exactly when the buyout is most likely to occur; (2) the buyer inherits the seller's basis and the contract's conversion deadline; and (3) the purchase price and premium obligations must be documented in the buy-sell so the arrangement is not later recharacterized. A cleaner structure is for each partner to buy a new policy on the other's life, with the agreement obligating the purchase.
3. Should Patel's trust-owned whole life policy be assigned into the buy-sell? Identify the estate tax and gift tax consequences, and state what you would advise.
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The trust-owned policy should not be assigned into the buy-sell.
Three problems. First, the ILIT, not Patel, owns the policy. Patel cannot assign what he does not own, so the trustee would have to transfer it - to Patel, to Okafor, or to the practice. Second, a transfer back to Patel, or an arrangement that leaves him with a binding obligation tied to the policy, can pull the entire $400,000 death benefit back into his gross estate under the three-year rule of IRC 2035 or as an incident of ownership. That defeats the purpose of the trust. Third, the trust beneficiaries are Patel's children; using the proceeds to buy practice shares converts their inheritance into an asset for Patel's partner.
The gift tax returns are a separate, smaller issue: if premiums exceeded the annual exclusion ($19,000 per beneficiary in 2025) in any year, a Form 709 is overdue and should be filed with a reasonable-cause explanation; if premiums stayed within the exclusion and Crummey notices were sent, no return may be needed.
Best practice: leave the ILIT intact as a family asset and fund the buy-sell with new policies owned by each partner or by the entity. Note that a transfer from the ILIT into a partnership in which Patel is a partner fits the partnership exception to the transfer-for-value rule, so income tax is not the issue - estate inclusion is.