The traps owners miss with company-owned buy-sell policies

A company-owned buy-sell plan looks simple: the business buys a policy on each owner, collects when one dies and uses the money to buy back that owner's shares. Most of the trouble does not come from the idea. It comes from details: the wrong entity holding a policy, a price nobody updated, a creditor who can reach the cash, a departing partner whose policy nobody planned for. This post lists eight traps in the order they usually surface, how each happens, what it can cost and how to avoid it.

It explains principles only. Entity type, state law and the wording of your agreement decide the result, so use it to prepare questions for a business attorney and a CPA, not to replace them. For the structure itself, start with funding a buy-sell agreement with life insurance and cross-purchase vs entity-redemption buy-sell plans.

Trap 1: The wrong entity owns the policy

How it happens. An owner has more than one entity: an operating company, a holding company, perhaps a family partnership that owns real estate. When the policy is bought, someone puts it in whichever entity is convenient, or in the name of the controlling shareholder's other company. The buy-sell agreement, meanwhile, says the operating company will redeem the shares.

What it costs. The party that collects the money may not be the party obliged to buy. If the holding company receives the proceeds but the operating company must buy, the cash has to be moved between entities. That can raise tax questions, create loans between affiliates and delay the closing. It can also raise a the transfer-for-value rule issue if a policy is moved later to fix the mistake, since a policy transferred for value can lose part of its tax-free treatment unless an exception applies.

How to avoid it. Match the policy owner and beneficiary to the entity named in the agreement. Write the legal name of the owner, the insured and the beneficiary into the agreement's schedule of policies, and check each application against that schedule before signing. If you want a different entity to hold the policies, say so in the agreement and have the attorney explain the effect.

Trap 2: The price and the policy drifted apart

How it happens. The agreement says the company will buy at a stated value or a formula, and the insurance was sized to that value years ago. The business then grew. Or it shrank, and the company now carries more insurance than it needs and pays premiums for protection it cannot use.

What it costs. Consider an invented example. Two owners signed an agreement when the company was valued at $2,000,000, so each share was $1,000,000, and the company bought a $1,000,000 policy on each. Several years later, an appraisal puts the company at $3,200,000, so each share is $1,600,000. If the agreement requires redemption at current appraised value, the company receives $1,000,000 at an owner's death and owes the estate $1,600,000. The gap is $600,000, to be paid from cash flow or a note. If the agreement instead uses the old stated price of $1,000,000, the estate receives a figure that no longer reflects the business and may contest it, or the family may feel shortchanged.

Both outcomes come from the same cause: nobody compared price and insurance. The reverse also happens. If the business is worth less, the estate may receive less than the policy pays, and the company ends up with surplus cash that the agreement did not anticipate.

How to avoid it. Choose a valuation method and put it in the agreement. Review value and face amounts at least annually; what to check and when in a buy-sell agreement's yearly review gives a calendar. If the agreement allows the estate to receive only the policy proceeds, say so explicitly rather than leaving it implied.

Trap 3: Forgetting that creditors can reach company-owned policies

How it happens. In an entity plan, the company owns the policy. Cash value, if the policy has any, and the proceeds that arrive after a death are company assets. Owners sometimes assume that "life insurance is protected," which is true of many policies owned by individuals in many states but not of company-owned policies and not uniformly everywhere. The protection of life insurance from creditors depends on state law, on who owns the policy and who is the beneficiary; the guide on can creditors take life insurance money? explains the general picture.

What it costs. If the company is sued or becomes insolvent, its creditors may be able to reach the cash value of its policies. After a death, a company's proceeds may sit in the same account as the money creditors have claims against, and the company's debts can compete with the estate for the cash. The estate is typically one claimant among several.

How to avoid it. Understand the exposure before choosing a structure. A cross-purchase places the policies in the owners' own hands, which can remove them from the company's creditors. A trust or insurance LLC that holds the policies can offer separation too, though it adds cost and requires tax review. If an entity plan is chosen, do not keep large cash surplus inside the policy longer than needed, and ask your attorney what protection your state gives and when it does not apply.

Trap 4: A departing partner's policy that nobody planned for

How it happens. A partner retires, sells out or is forced out. The company still owns a policy on that person. The agreement is silent, or it says only that the policy "shall be handled." Ownership, premiums and the beneficiary stay as they were.

What it costs. The company may keep paying premiums on a person who is no longer an owner. If the departing partner dies later, the company collects, but no buy-sell obligation requires it to use the money for anything. Worse, if the company wants to sell the policy to someone other than the insured, a partner or a corporation in which the insured is a shareholder or officer, the sale can trigger the the transfer-for-value rule and make part of the death benefit taxable. And a family that thought a departing partner's insurance would remain for them may be disappointed.

How to avoid it. Add a policy-disposition clause to the agreement. It typically gives the departing owner the right to buy the policy on their own life, often at a price tied to its cash value or to a formula, within a stated window, with the company or the other owners as alternates. If no one wants the policy, the clause can say it will be surrendered or allowed to lapse. A policy sold to the insured is one of the exceptions to the transfer-for-value rule, but have a tax professional confirm it for your facts.

Where the company owns a policy on an employee and has kept it after the person leaves, remember that the notice and consent requirements of IRC section 101(j) must have been satisfied at issue, ideally including consent for coverage to continue after employment. The companion checklist, the notice and consent checklist for employer-owned life insurance, explains the steps.

Trap 5: Skipping notice and consent on company-owned policies

How it happens. The owners think of the policy as a business arrangement among themselves and treat the paperwork as a formality. They apply without written notice and consent to the owner-employees being insured.

What it costs. For employer-owned life insurance contracts issued after August 17, 2006, IRC section 101(j) can limit the tax-free amount of the death benefit to the premiums the company paid, unless notice and consent were given before issue and an exception applies. Exceptions include insureds who were directors, highly compensated employees or individuals, or employed within 12 months before death, and also certain cases where the money goes to the insured's family or is used to buy an ownership interest from them. A buy-sell is exactly the kind of use some of those exceptions contemplate, but the paperwork still has to be in order. Missing it can turn part of an expected tax-free payout into taxable income to the company, and it is a mistake that cannot be fixed afterward with a backdated form.

How to avoid it. Treat the notice and consent as part of the application. The company reports its employer-owned contracts on Form 8925 with its tax return each year (IRS, About Form 8925). Keep the signed forms with the policy.

Trap 6: Ignoring the difference between S corporations, C corporations and LLCs

How it happens. An agreement is copied from a template drafted for a different kind of entity. The template says "the company will redeem the shares," but the business is an LLC taxed as a partnership with an operating agreement that uses membership interests and capital accounts. Or a C corporation's plan is adopted wholesale by an S corporation.

What it costs. Without trying to cover the tax details, a few principles show why entity type matters.

• Basis. When a surviving owner buys an interest directly, as in a cross-purchase, the buyer generally gets a basis in the interest equal to the price paid. When the entity redeems it, the remaining owners generally do not get a higher basis in their own interests. That affects their later taxable gain on a sale. See cost basis for the idea in general terms.
• Estate tax value. A corporation's value can include proceeds from policies it owns when valued for federal estate tax, as the Supreme Court held in Connelly v. United States on June 6, 2024. The federal basic exclusion is $15,000,000 per person in 2026, so the issue arises only for larger estates, but some states tax smaller ones. The estate tax exposure check gives a first pass.
• Governing documents. An S corporation has restrictions on classes of stock and shareholder types that an agreement must respect. A partnership-taxed LLC has its own rules on what happens when a member leaves. A legal review should confirm that the buy-sell language works inside the entity's rules.
• Terminology. Terms like "redemption," "liquidation of a member's interest" and "purchase" carry different tax meanings. Using the wrong word in an agreement can confuse the tax result.

How to avoid it. Have the attorney draft or revise the agreement for the entity you have, not a generic one. If the entity changes, say from a partnership to a corporation, treat that as an event that requires reviewing the agreement and the policy ownership.

Trap 7: Letting premiums, ownership and beneficiary designations drift

How it happens. A premium notice goes to an old address. A card expires. The policy is renewed under a different name after an acquisition. A beneficiary form lists "the estate" or an individual owner instead of the company. No one notices because nothing happens until a death.

What it costs. A lapse means no payout. A wrong beneficiary means the money goes to a person or an estate rather than to the company that must buy the shares, which defeats the plan and can leave the company owing a purchase price it cannot afford. After a lapse, the insurer may allow reinstatement for a limited time with proof of insurability, but that depends on the contract and on the partner's health.

How to avoid it. Once a year, get written confirmation from each insurer of status, owner, beneficiary and premium due date. Have one person responsible, and a second person who can step in. Read the policy's grace period provisions so everyone knows how long a missed payment is tolerated; it is commonly 30 or 31 days. When there are many policies, keep a one-page schedule.

Trap 8: Treating the policy as the whole plan

How it happens. The owners buy the insurance and file the agreement. They assume the job is done.

What it costs. Several gaps remain after the death benefit arrives. A death buyout does not fund a disability buyout. It does not solve a shortfall between price and proceeds. It does not put a successor in the seat or address the lender's concerns. It does not coordinate with the family's personal planning, such as the estate documents and income protection that the owner's household needs. A surviving owner who becomes the sole owner may then have no succession plan of their own; see a succession checklist for a one-person business and your death.

How to avoid it. Make a one-page list of what the insurance covers and what it does not: death, but not disability; a price up to the face amount, but not above; the purchase, but not working capital. Then decide how each gap is filled. The guide on life insurance for small business owners shows how buy-sell coverage fits with key person and personal coverage.

A short list to check this month

• Is the owner of each policy the entity the agreement names?
• Does the policy amount match the price the agreement produces today?
• Who can reach the cash value and proceeds if the company has creditors?
• What happens to each policy if an owner leaves?
• Are the notice and consent forms signed and filed, and is Form 8925 on the tax calendar?
• Does the agreement fit the entity type, and does the CPA agree?
• Has someone confirmed with each insurer that premiums are current and the beneficiary is correct?
• What does the plan not cover, and who is working on that?

Key takeaways

• The wrong entity owning a policy, or a beneficiary that does not match the buyer, can leave the money in the wrong place at the moment it is needed.
• A price that nobody updates and a policy sized to an old value produce a shortfall or surplus; in the example, a $1,600,000 share against a $1,000,000 policy leaves $600,000 to fund.
• Company-owned policies and their proceeds are company assets and may be reachable by company creditors, so structure and state law matter.
• A departing partner needs a policy-disposition clause, and any transfer of an existing policy should be checked against the transfer-for-value rule.
• Entity type changes the basis, estate tax and drafting questions, so review the agreement with an attorney and CPA whenever the entity or the owners change.