Funding a buy-sell agreement with life insurance

A buy-sell agreement is a contract among a business's owners that says what happens to an owner's share at death, disability, divorce or departure, and at what price. Life insurance funds the death scenario: when an owner dies, the policy pays cash that lets the surviving owners or the company buy the share from the family, so the family gets money instead of a stake in a business they may not want to run. The structure you pick, who owns the policies and how the price is set, determines the tax result.

Why the agreement and the insurance both matter

Without an agreement, a deceased owner's share passes under their will or trust. The heirs may become partners with the survivors, or the survivors may be unable to raise the cash to buy them out. A signed agreement with a funding source solves three problems at once: the family is paid, the survivors keep control, and the price is settled in advance instead of argued over.

An agreement with no funding is only a promise. Banks do not always lend against a deceased owner's goodwill, and paying a large sum out of cash flow can sink the business. That is where insurance, usually term life insurance while the owners are working, comes in.

What the agreement should say

A lawyer drafts the agreement; the insurance decisions follow from these points.

• Triggering events. Death is the standard trigger. Disability, retirement, divorce and bankruptcy are also commonly covered. Life insurance funds death; disability buyouts need a separate funding source.
• Mandatory or optional. A mandatory ("must buy, must sell") agreement binds both sides. An option gives the survivors the right but not the duty to buy.
• The price. A fixed price, a formula (a multiple of earnings, for example), an independent appraisal at the time of death, or a price updated on a schedule. A fixed price that is never revisited drifts out of line with the business.
• Payment terms. Lump sum from insurance, with any shortfall paid by promissory note.
• Policy rules. Who owns the policies, what happens to a policy if an owner leaves, and the right of the departing owner to buy the policy on their own life.

Two ways to structure the insurance

The full comparison, including basis step-up and the estate tax consequences, is in cross-purchase vs entity-redemption buy-sell plans. For a two-owner company, a cross-purchase agreement is simple. With four or more owners, the number of policies becomes unwieldy, which is why advisers sometimes use a trust or a partnership to hold all the policies (the "trusteed" or "insurance LLC" cross-purchase). An entity-redemption agreement keeps the policy count down but has its own estate tax issue, discussed next.

The Connelly decision

In Connelly v. United States, decided June 6, 2024, the Supreme Court unanimously held that life insurance proceeds a corporation receives to redeem a deceased shareholder's shares are a corporate asset that increases the company's value for federal estate tax purposes. The Court reasoned that the company's contractual duty to redeem shares at fair market value did not offset those proceeds, because a redemption at fair value does not change what any shareholder's stake is worth (Supreme Court opinion summaries from Gibson Dunn). In that case the company was valued at just under $4 million and the proceeds used for the redemption were $3 million, and the estate owed a deficiency of $889,914.

Practical consequences:

• If you use a corporate redemption plan, the company's value in your estate may include the insurance proceeds, in addition to the purchase price that was paid.
• For 2026, the federal estate tax basic exclusion is $15,000,000 per person according to the IRS, so many small-business owners are not exposed to federal estate tax. Some states tax smaller estates; see state estate and inheritance taxes and life insurance.
• Owners above those thresholds, or in states with lower ones, are the ones who most often revisit a redemption plan, often by moving to cross-purchase. Changing structures can create transfer-for-value problems.

How to size and place the coverage

1. Value the business. Use the agreement's formula or a current appraisal, not a guess.
2. Compute each owner's share. A 40% owner in a $2.5 million business implies $1 million.
3. Decide the insured amount. Many plans insure the full value; some insure part and use a note for the rest.
4. Choose the owner of the policy according to the structure (owners, the company, or a trust).
5. Pick the policy type. Term for a defined horizon; permanent if the agreement must be funded whenever an owner dies. See the types of life insurance, explained.
6. Schedule a review. Revisit values at least every year or two, and after a major change in ownership or revenue.

A hypothetical example

Say three equal partners, ages 38, 45 and 52, run an agency valued at $3 million, so each share is worth $1 million. Under a cross-purchase plan each partner would own two $500,000 policies, one on each of the others, six policies in all, with premiums that differ because of age. Under a corporate redemption plan, the company would own three $1 million policies. The numbers are invented for illustration, not market prices, and the better structure depends on tax, cost and the partners' situation.

Tax points

• Death benefit. Proceeds are generally income tax-free, but the transfer-for-value rule can make them taxable if a policy changed hands for value. The rule has exceptions for transfers to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. See the transfer-for-value rule.
• Premiums. Under IRC section 264(a)(1), premiums are not deductible when the payer is a beneficiary of the policy, which is the case in both structures.
• Employer-owned policies. A company-owned policy on an owner or employee can be subject to the notice and consent rules of IRC section 101(j) and Form 8925 reporting; see key person life insurance for how that works.
• Basis. A cross-purchase generally gives the surviving owners a stepped-up basis in the shares they buy; a redemption generally does not raise the remaining owners' basis.

A business attorney, a CPA and an insurance professional should work together; the agreement and the policies must match, and many problems come from policies that were never updated after the agreement changed.

Key takeaways

• A buy-sell agreement sets who buys an owner's share and at what price; life insurance supplies the cash at death.
• Cross-purchase puts the policies in the owners' hands; entity redemption puts them in the company's.
• Connelly v. United States (June 6, 2024) means company-owned proceeds can raise the company's estate tax value.
• Keep the valuation current and review the agreement and policies together every year or two.
• Transfer-for-value and estate tax effects make a lawyer-drafted agreement worth the cost.