Funding a Buy-Sell Agreement With Life Insurance

Why buy-sell planning matters

Picture a business with two equal owners. One dies. Immediately:

• The deceased owner's share usually passes to their family or estate.
• The surviving owner may now be in business with a spouse or heirs who never worked there.
• The family may want cash, not a stake in a company they can't run.
• Someone needs a large sum of money, quickly, at a fair price.

A buy-sell agreement answers these questions in advance. Without funding, the survivor may have to borrow, drain business cash, or pay the family over years. All of these strain the business at its weakest moment.

How does life insurance fund the buyout?

Policies are taken out on each owner. When an owner dies, the death benefit provides the cash to buy their interest at the price or formula set in the agreement. The family receives fair value, the surviving owners keep control, and the business doesn't have to come up with the money from operations.

Cross-purchase vs. entity redemption

There are two common structures. Your attorney will decide which fits; the insurance is then designed to match.

Cross-purchase: Each owner owns a policy on the other owners. When one dies, the survivors receive the proceeds and buy the deceased owner's share directly.

• The policies sit outside the company.
• The buying owners may get a higher tax basis in the shares they purchase, depending on circumstances.
• With many owners, the number of policies grows quickly. Three owners need six policies; five owners need twenty. A trust or partnership arrangement is sometimes used to simplify this.

Entity redemption (stock redemption): The business owns one policy on each owner. When an owner dies, the company receives the proceeds and redeems (buys back) the shares.

• Simpler to administer: one policy per owner.
• The policies are company assets, which affects valuation. That's where the Connelly decision matters.

What did Connelly v. United States change?

In 2024, the U.S. Supreme Court decided Connelly v. United States. A closely held corporation owned life insurance to redeem a deceased shareholder's shares. The Court held that the corporation's obligation to redeem the shares did not offset the life insurance proceeds when valuing the company for federal estate tax. In effect, the insurance increased the company's value, and with it the estate tax owed on the deceased owner's shares.

What it means in practice:

• Entity-owned buy-sell arrangements are not automatically wrong, but they deserve a fresh look, especially for larger businesses and owners whose estates may be exposed to estate tax.
• Plans set up before 2024 should be reviewed by your attorney and CPA.
• Changing structure (for example, moving from entity redemption to cross-purchase) can mean transferring existing policies. That can trigger the transfer-for-value rule and make death benefits partly taxable if not handled correctly. Don't move policies without professional review.

How much life insurance does a buy-sell need?

Start with the agreement and a current business valuation, not a round number.

• What is the business worth today, and how is that value determined (fixed price, formula, or appraisal)?
• When was the valuation last updated?
• What is each owner's percentage?
• Will insurance fund the full buyout or only part of it?
• Is the business growing fast enough that coverage will fall behind?

A $1 million policy doesn't fund a $3 million obligation just because $1 million sounded like a lot when it was purchased. Many agreements include a valuation review every year or two, and insurance should be reviewed on the same schedule.

Term or permanent coverage?

Term can work when owners are younger, cash is tight, and a planned exit or sale is expected within the term. Its weakness is that a buy-sell obligation often lasts longer than the term, and owners may become uninsurable along the way.

Permanent coverage is often considered when the obligation is expected to last until an owner dies, regardless of when that happens. It costs more and needs regular review. See permanent life insurance.

A common middle path is convertible term coverage, which can later be converted to permanent coverage without new medical underwriting if the policy allows it.

Employer-owned policy rules may apply

When the business owns the policies (entity redemption), the notice-and-consent requirements of IRC §101(j) generally apply, and they must be completed before the policies are issued. Our key person insurance guide explains those steps.

A better buy-sell planning process

1. 1Attorney drafts or updates the agreement, including the triggering events and the structure.
2. 2Valuation method is set, and a current value is established.
3. 3The funding need is calculated for each owner.
4. 4Insurance is designed: who owns each policy, who is insured, the beneficiaries, the amounts, and the policy type.
5. 5Underwriting is completed for each owner.
6. 6Policies are matched to the agreement so ownership and beneficiaries align with the legal structure.
7. 7The plan is reviewed regularly: values change, ownership changes, health changes.

Common buy-sell problems we see

• The agreement exists, but nothing funds it.
• The policies exist, but the agreement was never signed or updated.
• The valuation is years out of date.
• Policy ownership or beneficiaries don't match the agreement's structure.
• One owner became uninsurable before coverage was put in place.
• A policy lapsed and nobody noticed.
• An entity redemption plan hasn't been revisited since Connelly.