A buy-sell agreement is a binding contract among the owners of a closely held business that forces a sale of an owner’s interest, at a price set by the agreement, when a triggering event occurs. Death is the most common trigger, but the same contract typically covers disability, retirement, voluntary departure, and divorce. The point is to remove the uncertainty that otherwise surrounds a private business interest: the remaining owners keep control, the departing owner or their estate receives a fair, predictable payment, and no one has to negotiate a price during a crisis.
The structure you choose and the way you fund it drive nearly everything about how the agreement performs when it’s actually needed. A 2024 Supreme Court decision changed the calculus for one of the two most common structures, so any agreement drafted before then deserves a fresh look.
What a Buy-Sell Agreement Actually Does
The agreement creates a mandatory two-way obligation. The departing owner (or their estate) must sell, and the remaining owners or the business itself must buy. Neither side can walk away. That mutual lock-in is what gives the agreement its power in a market where private business shares have no public buyers.
Most agreements also include a right of first refusal. An owner who wants to leave voluntarily has to offer their shares to the other owners or the entity first, at the agreement price. Only after the existing parties decline can the owner shop the interest to an outsider, and even then usually not below the internal price. This restriction is a legally recognized way to preserve the character and management of a private business.
The obligations bind heirs, estates, and legal representatives, not just the current signatories. To keep future owners bound as well, the agreement should be referenced in the corporate bylaws or operating agreement. If a party refuses to honor the buyout, the other side can sue for breach and, in most cases, force the sale.
Triggering Events
Death gets the most attention because life insurance makes it the easiest event to fund, but a complete agreement addresses several other scenarios.1NAEPC Journal of Estate and Tax Planning. The 23 Ds of Buy-Sell Agreements Retirement and voluntary resignation are straightforward on paper, but they happen while everyone is alive, so there is no death benefit to draw from and the buyout has to be funded some other way.
Disability is sometimes called the “living death” in planning circles because it creates a financial drain without the clean resolution death provides. The owner still holds shares but can’t contribute, and the other owners carry the load. Disability buyout insurance addresses this, typically after a waiting period of 18 to 24 months on the theory that an owner who hasn’t recovered by then is unlikely to return. The insurer then pays a lump sum, installments, or a combination to fund the purchase. Many agreements either ignore disability or define it so vaguely that the clause is unenforceable when it matters.
Divorce is the trigger owners forget. Without a provision, a former spouse can end up owning a chunk of the business through a property settlement. A well-drafted agreement forces any shares caught in a divorce proceeding to be sold back to the remaining owners or the entity rather than transferred to the ex-spouse. In community property states, getting spousal consent to the agreement at the outset makes it more likely to survive if a divorce happens later.
How Life Insurance Funds the Buyout
Life insurance is the standard funding tool because it delivers cash exactly when a death-triggered buyout needs it. Without insurance, most closely held businesses would have to liquidate assets or borrow to buy out an estate. A policy pays a lump sum shortly after death, giving the buyers immediate capital to complete the purchase at the agreed price.
The tax treatment is what makes it work. Amounts paid under a life insurance contract by reason of the insured’s death are generally excluded from the beneficiary’s gross income under federal law.2Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits The full death benefit goes toward the buyout rather than being reduced by an income tax bill. The owners or the business pay premiums over time, and the proceeds show up when they’re needed most.
Who owns the policy and who receives the proceeds is the question that decides which structure you have.
Entity Purchase vs. Cross-Purchase
In an entity purchase (or stock redemption) agreement, the business owns the life insurance policies on each owner, pays the premiums, and receives the death benefits. When an owner dies, the business uses those proceeds to redeem the shares. The redeemed shares are retired, and each surviving owner’s percentage of ownership goes up without them personally spending anything.
This structure appeals to businesses with several owners because the company needs only one policy per owner rather than a web of individual policies. Central premium payments reduce the risk of a lapse.3Southern Arizona Estate Planning Council. Buy-Sell Agreement Planning Strategies The trade-off is that surviving owners get no increase in their cost basis. They still hold the same shares at the same original basis. If they sell the business later, that unchanged basis means a larger taxable gain.
A cross-purchase agreement puts the obligation on the individual owners. Each owner buys, pays for, and is the beneficiary of a policy on every other owner. The math grows fast: the number of policies is N × (N − 1), where N is the number of owners.4The CPA Journal. Structuring Corporate Buy-Sell Agreements A four-owner business needs twelve policies; a seven-owner business needs 42.
The payoff is that surviving owners are personally buying the deceased owner’s shares, so they get a new cost basis equal to the purchase price.4The CPA Journal. Structuring Corporate Buy-Sell Agreements That stepped-up basis reduces capital gains taxes on a later sale. Smaller partnerships with two or three owners tend to favor cross-purchase for this reason. The transaction also stays off the company’s balance sheet.
Trusteed Cross-Purchase
A trusteed cross-purchase solves the policy-count problem. A third-party trustee holds one policy per owner, collects the death benefit, and distributes the proceeds under the agreement. A four-owner business drops from twelve policies to four. The underlying transaction is still a purchase between individuals, so the surviving owners still get the basis increase.5Principal Financial Group. Trusteed Cross-Purchase Agreements
Wait-and-See (Hybrid) Agreements
A wait-and-see agreement defers the choice until a triggering event actually happens. Typically the corporation has the first option to redeem the shares. If it declines or buys only a portion, the remaining owners have a second option to buy individually. If they also pass, the corporation is obligated to buy whatever’s left. The parties get to pick the structure that produces the best tax result under the facts that actually exist, rather than guessing years ahead.
The Connelly Decision and Why It Changed the Analysis
In June 2024, the Supreme Court decided Connelly v. United States and reshaped how entity-purchase agreements interact with estate taxes. Crown C Supply was owned by two brothers and held $3.5 million in life insurance on each to fund a potential redemption. When Michael Connelly died, the company redeemed his 77.18% stake for $3 million.
The question was whether the insurance proceeds earmarked for the redemption counted as a corporate asset when valuing the company for estate tax purposes. The Court held they did: life insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value, and the company’s obligation to redeem shares does not offset that increase.6Supreme Court of the United States. Connelly v. United States, 602 US (2024)
The IRS valued Crown at $6.86 million rather than $3.86 million, which pushed Michael’s share value from roughly $3 million to $5.3 million and generated an additional $889,914 in estate taxes. The Court itself noted that a cross-purchase agreement would have avoided the problem, because the insurance proceeds would have gone to the surviving brother personally and never touched the corporate balance sheet.6Supreme Court of the United States. Connelly v. United States, 602 US (2024)
Any business currently using an entity-purchase agreement funded by life insurance should have it reviewed. The insurance meant to fund the buyout now inflates the estate tax bill on the very shares being bought back.
Setting the Price
The agreement has to say how the purchase price will be calculated. Three approaches are common.
A fixed-price method sets a specific dollar figure the parties agree on. It’s simple, but it requires regular updates. A valuation locked in five years ago may be nowhere near current. Owners who pick this method and forget to revisit it create exactly the dispute the agreement was meant to prevent.
A formula-based method calculates value using agreed metrics: a multiple of earnings, revenue, or book value. It adjusts as performance changes, but the formula itself can go stale if industry multiples shift.
A professional appraisal at the time of the triggering event produces the most current and defensible number. An independent appraiser evaluates the business under the conditions that actually exist. The downside is cost and delay, and the parties may still argue about the appraiser’s conclusions.
One drafting detail matters more than owners expect: the exact valuation standard. “Fair market value” typically implies that minority and marketability discounts may apply, reducing the price below a straight pro-rata share of the whole business. “Fair value” generally excludes those discounts. Ambiguous phrases like “appraised market value” have produced litigation because the parties disagreed later about whether discounts applied. Spelling out the standard eliminates the fight before it starts.
Making the Price Stick for Estate Tax
Fixing a price in the agreement doesn’t automatically bind the IRS. To use the agreement price as the estate tax value, the agreement must satisfy three tests under federal law:7Office of the Law Revision Counsel. 26 USC 2703 – Certain Rights and Restrictions Disregarded
- It must be a bona fide business arrangement, not just a tax-avoidance device.
- It cannot be a mechanism to pass property to family members for less than fair value.
- Its terms must be comparable to what unrelated parties would agree to at arm’s length.
Family-owned businesses draw the heaviest scrutiny. When all the owners are related, the IRS looks hard at whether the agreement price is artificially low. An agreement among unrelated partners is easier to defend because no one has a built-in reason to undervalue the shares. Failing these tests doesn’t just mean an adjustment. It can mean the estate owes far more than the family planned for.
Two Tax Traps to Watch
Two federal rules can strip the income-tax-free treatment off a death benefit if policies aren’t handled carefully. Both come up often in buy-sell planning because policies frequently move between owners or the business.
Transfer-for-Value
If a life insurance policy is transferred for valuable consideration, meaning someone pays to acquire an existing policy, the death benefit generally loses its tax-free status. The beneficiary can exclude only what was paid for the policy plus later premiums; the rest is taxable income. This is a real risk when owners restructure a buy-sell arrangement and move policies between themselves or the business.
Several exceptions preserve tax-free treatment. The exclusion survives when the policy is transferred to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.8Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits These exceptions matter most when converting between cross-purchase and entity-purchase structures. Getting the transfer wrong can turn a tax-free death benefit into a partially taxable one.
Employer-Owned Life Insurance
When a business owns a policy on an employee or owner, Section 101(j) adds notice and consent requirements. Miss them and the exclusion is capped at the total premiums the business paid; everything above that becomes taxable income to the company.
Before the policy is issued, the insured must be told in writing that the business intends to insure their life and the maximum face amount of coverage. The insured must consent in writing to being covered, acknowledge that coverage may continue after they leave the business, and be informed that the business will receive the proceeds.8Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits Skipping any of these steps is a mistake that only surfaces after someone dies, when it’s too late to fix.
Funding the Events Insurance Doesn’t Cover
Life insurance handles death efficiently. Retirement and voluntary departure happen while both sides are alive, so there is no death benefit to draw from. Two backup approaches are common.
A sinking fund sets aside business profits over time in an account earmarked for future buyouts. The risk is that an owner departs before the fund is large enough. For C corporations there’s also an accumulated earnings tax exposure if the company holds more than the business reasonably needs; funding a stock redemption qualifies as a reasonable business need, but the company should document that purpose clearly.9Internal Revenue Service. IRM 4.10.13 – Certain Technical Issues
Installment notes let the buyer pay over time with interest rather than in a lump sum. This spares the business from producing the full amount at once, but the seller waits for their money and carries the risk that the business can’t keep up. Many agreements pair life insurance for death events with installment terms for retirement or voluntary departures, using different tools for different exits.