Funding a Two-Partner Buy-Sell When One Partner Cannot Be Insured
Dr. Okafor and Dr. Lindqvist are 52-year-old equal partners in a Towson dental practice valued at $2.4 million, or $1.2 million per interest. They want a written buy-sell agreement so that on a death the survivor, or the practice, purchases the decedent's interest. Dr. Okafor is in excellent health. Dr. Lindqvist has type 2 diabetes, hypertension, and a coronary stent placed last year; a preliminary underwriting inquiry indicates he would be declined for $1.2 million of fully underwritten coverage. The practice can commit $18,000 per year to funding. Both partners plan to retire at 67. They have no agreement of any kind today, and each has a spouse and minor children.
1. Should the partners use a cross-purchase or an entity-redemption arrangement? Explain the tax consequences that drive your recommendation and how many policies are needed.
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Recommend a cross-purchase (or an LLC/partnership with a cross-purchase overlay) - the basis step-up is the deciding factor.
- Entity redemption: after the redemption, the surviving partner's basis in his interest is unchanged. When he later sells or retires, the entire $2.4 million is gain. Redemptions can also trigger accumulated-earnings exposure and, in a corporation, no basis step-up at all.
- Cross-purchase: each partner buys the decedent's interest directly and receives a step-up in basis under §1014 to the purchase price, so a later sale produces little or no gain. Here that saves tax on roughly $1.2 million of appreciation.
- Policy count: two policies in a two-partner cross-purchase - Okafor owns a policy on Lindqvist and is beneficiary, and vice versa. (An entity arrangement would need only one policy per insured owned by the business, but forfeits the step-up.)
- Practical caveats: cross-purchase requires identical value formulas and synchronized annual review; if the ownership structure changes, the plan must be restructured.
2. Lindqvist is likely uninsurable at this face amount. Design a workable funding plan.
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The two risks are not symmetrical - exploit that.
- Insure Okafor anyway. A $1.2 million policy on Okafor, owned by Lindqvist, fully solves the "Okafor dies first" scenario, and Okafor's clean health makes it cheap.
- Do not let the uninsurable partner's status stall the agreement. Execute the buy-sell with a funding schedule that names a source for each side: insurance for Okafor's interest; for Lindqvist's interest, a sinking fund (annual deposits into a segregated account or a funding trust) plus an installment promissory note from Okafor with a stated interest rate, secured by the purchased interest.
- Consider a "wait-and-see" or one-way buy-sell if the partners want flexibility: the survivor has the option, or the entity has the first option, to buy. But a one-way arrangement leaves Lindqvist's family exposed if Okafor dies first - so pair it with the policy in step 1.
- Re-underwrite periodically. A stent plus controlled diabetes may be insurable in two to three years at a rated table if his A1c, blood pressure, and cardiac follow-up are documented; build a reapplication right into the agreement.
- Avoid the trap of funding both sides with term insurance on Okafor only and calling the problem solved - half the exposure remains unfunded.
3. Given the $18,000 annual budget and a horizon to age 67, what product structure fits Okafor's policy, and what happens if he dies at 68?
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Level term to age 67 with a conversion privilege, sized to the $1.2 million obligation.
- A 15-year level term policy on a healthy 52-year-old is comfortably inside the budget, whereas $1.2 million of whole life or guaranteed universal would consume it many times over and starve the sinking fund.
- Conversion privilege preserves flexibility: if the practice value grows or the partners push retirement out, Okafor can convert some term to permanent without new evidence of insurability - critical given that his health could change.
- Buy a guaranteed renewable/annual renewal term alternative only if it is materially cheaper; otherwise level term matches the liability.
- The age-68 death scenario: the term has expired, so the agreement must be funded another way. Two fixes: (a) structure the agreement so the surviving partner's obligation continues but payment is by installment note, and (b) require the partnership to review and re-fund the arrangement at retirement, at which point the practice is typically sold anyway and the buy-sell obligation ends with the sale. Document this review obligation in the agreement so no one assumes coverage exists when it does not.