Buy-sell agreement insurance is life or disability coverage that gives business co-owners the cash to buy out a partner’s share when death, disability, retirement, or another triggering event forces a change in ownership. Without that funding source, the surviving owners have to sell assets, borrow, or accept the departing owner’s heirs as new partners. The right policy type, ownership structure, and valuation method decide whether the plan works when it’s needed.
What the Insurance Actually Funds
Three policy types show up in buy-sell planning, and each answers a different question.
Term life insurance pays a death benefit if an owner dies within the coverage window, which is usually set to match how long the owners expect to be in business together. Premiums are lower than permanent coverage, which suits younger owners or businesses that plan to revisit succession in ten or twenty years. If the term expires and no one has died, the coverage disappears and the agreement is unfunded.
Permanent life insurance (whole life or universal life) covers the insured for their entire lifetime and accumulates cash value alongside the death benefit. The cash value grows tax-deferred and can be borrowed against if the business needs liquidity before a triggering event. Premiums run significantly higher, but the policy never expires, which matters when owners intend to stay in business indefinitely.
Disability buy-out insurance handles the case where a partner becomes permanently unable to work but doesn’t die. Unlike standard disability income policies that replace a portion of lost wages, a disability buy-out policy pays the funds needed to purchase the disabled owner’s equity stake. These policies impose an elimination period of 12, 18, or 24 months before benefits begin. Once benefits start, the insurer does not require ongoing proof that the disability continues. Longer elimination periods bring lower premiums. A disability buy-out policy only works when a written buy-sell agreement spells out the valuation, the payment structure, and the definition of disability the policy will use.
Cross-Purchase or Entity-Purchase
Once you know what policies to buy, the next question is who owns them. That choice drives the tax outcome years later.
Cross-Purchase Agreements
In a cross-purchase, each owner personally buys and owns a policy on every other owner. When a partner dies, the surviving owners collect the death benefits and use the proceeds to buy the deceased partner’s interest directly from the estate. The transaction happens between individuals, not through the business.
The tax advantage is real. Because the surviving owners pay for the shares out of pocket, their cost basis in the newly acquired shares equals what they paid. That higher basis reduces capital gains tax if they later sell the business. The administrative headache is also real. Two partners need two policies. Three partners need six. Five partners need twenty. The number of policies grows fast, and coordinating premiums across owners of different ages and health profiles gets complicated.
Entity-Purchase (Stock Redemption) Agreements
An entity-purchase flips the ownership. The business buys a policy on each owner, pays the premiums, and collects the death benefit. The business then uses the proceeds to redeem the deceased owner’s shares. Only one policy per owner is needed regardless of how many partners exist.
The simplicity comes with strings. Because the business owns the policies, they are employer-owned life insurance contracts subject to special federal rules. Before the policy is issued, three requirements must be met: the employee must receive written notice that the business intends to insure their life and the maximum face amount; the employee must give written consent and acknowledge that coverage may continue after they leave the company; and the employee must be informed that the business will be a beneficiary of any death proceeds.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits Skip any of those steps and the death benefit above total premiums paid becomes taxable income to the business rather than a tax-free payout. That single failure can gut the funding plan.
There is also a basis consequence. In an entity-purchase, the survivors don’t buy anything directly, so they keep their original basis in their own shares. Their percentage ownership rises because fewer shares are outstanding, but the basis doesn’t move. When they later sell, capital gains are calculated from that original, lower basis, producing a much larger tax bill than a cross-purchase would have delivered.
Trusteed and Wait-and-See Structures
A trusteed cross-purchase addresses the multiple-policy problem. A third-party trustee owns and manages a single policy on each owner instead of every owner insuring every other owner separately. When an owner dies, the trustee collects the proceeds and carries out the buyout according to the trust’s terms. The survivors still get the cost-basis benefit of a cross-purchase, and the policies sit outside the business entity, generally beyond the reach of business creditors.
A wait-and-see agreement (sometimes called a hybrid) delays the structural decision until the triggering event actually happens. The business gets the first option to redeem the departing owner’s interest. Any shares the business doesn’t redeem can be purchased by the surviving owners individually, functioning as a cross-purchase for that portion. Any remaining shares the individual owners don’t take must be purchased by the business. The flexibility lets the owners and their advisors pick the structure that produces the best tax result at the time.
The Connelly Decision Changed the Math
In June 2024, the Supreme Court reshaped how entity-purchase plans are valued for estate tax. In Connelly v. United States, the Court held that life insurance proceeds payable to a corporation count as a corporate asset that increases the company’s fair market value for estate tax purposes.2Justia US Supreme Court. Connelly v. United States, 602 U.S. (2024) The estate argued that the corporation’s obligation to use those proceeds to redeem shares should offset the insurance value. The Court disagreed, reasoning that a redemption at fair market value has no effect on any shareholder’s economic interest, so no hypothetical buyer would treat the redemption obligation as reducing the share price.
The practical effect: suppose a corporation holds a $3 million life insurance policy to fund a stock redemption. When the insured owner dies, that $3 million becomes a corporate asset before the redemption occurs. The estate is valued at the moment of death, so the deceased owner’s shares include a proportional claim on that $3 million. Estate tax is calculated on the inflated value, and then the $3 million is spent on the redemption. The estate owes tax on value it never actually receives as extra cash.
Any business currently using an entity-purchase structure funded by life insurance should revisit the arrangement with a tax advisor. The Court’s opinion noted that cross-purchase agreements and trust-based structures avoid this trap because the insurance proceeds never become a corporate asset.2Justia US Supreme Court. Connelly v. United States, 602 U.S. (2024)
Tax Rules That Break Funded Plans
Premiums Are Not Deductible
Premiums paid for buy-sell life insurance are not deductible. Federal law prohibits deducting premiums on any life insurance policy where the taxpayer is directly or indirectly a beneficiary.3Office of the Law Revision Counsel. 26 USC 264 – Certain Amounts Paid in Connection With Insurance Contracts In a cross-purchase, each owner pays personally and gets no deduction. In an entity-purchase, the business pays and likewise gets no deduction. Disability buy-out premiums are also nondeductible, though the benefits are generally received tax-free.
The Insured’s Status Matters for the Income-Tax Exclusion
Death benefits normally arrive income-tax-free under the general exclusion for life insurance proceeds. For entity-purchase arrangements, that exclusion applies only if the notice and consent requirements described above are satisfied before the policy is issued. Even when they are, the exclusion applies only if the insured falls into one of the statute’s categories: an employee within the 12 months before death, a director, or a highly compensated employee or individual at the time the policy was issued.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits Most co-owners of closely held businesses meet at least one, but confirm before assuming the proceeds will be tax-free.
Transfer-for-Value
Reassigning an existing policy to a new owner for valuable consideration can strip the death benefit of its tax-free treatment. Under the transfer-for-value rule, the recipient can only exclude from income the amount they paid for the policy plus subsequent premiums; the rest of the death benefit becomes taxable as ordinary income.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
This matters most when businesses restructure. If a three-owner partnership becomes a two-owner partnership and the owners want to shuffle existing policies rather than buy new ones, a transfer for consideration could trigger the rule unless an exception applies. The statute carves out exceptions for transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, and to a corporation in which the insured is a shareholder or officer.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits The partner exception is notably broader than the corporate shareholder exception, which makes partnerships and LLCs taxed as partnerships more flexible when moving policies among owners.
Setting the Face Amount
The valuation method in the buy-sell agreement drives the face amount of the policy. Get it wrong and the insurance either leaves a shortfall the survivors must scramble to cover, or overfunds the buyout and wastes premium dollars.
A fixed-price agreement is the simplest approach. The owners agree on a dollar value and write it into the agreement. The danger is staleness. If the owners don’t update the number annually, it drifts from reality. Some agreements require annual updates and provide a fallback formula, such as adjusting the last agreed value by changes in net worth, when owners miss the deadline for more than two years. Even with safeguards, a stale price creates a strong incentive for the departing owner’s estate to challenge the buyout.
A formula-based approach ties the price to a financial metric like a multiple of earnings. It updates automatically with each year’s results, avoiding the staleness problem. The risk is that a single formula may not capture true value during unusual years, such as a temporary downturn.
An independent appraisal by a certified valuation professional produces the most defensible number, but it takes time and costs money. Appraisal fees for buy-sell purposes typically run from a few thousand dollars for a straightforward small business to $30,000 or more for complex operations. Many agreements call for the appraisal at the time of the triggering event, which means the insurance face amount is based on the most recent available estimate and may need adjustment.
Triggers Insurance Doesn’t Fund
Death and disability draw the attention because they’re the events insurance directly funds. A well-drafted buy-sell agreement covers more than that:
- Retirement or voluntary departure, so a retiring owner can sell back their interest under set terms rather than hold equity indefinitely after leaving operations.
- Divorce, so the remaining owners can purchase any shares that would otherwise pass to an ex-spouse as marital property.
- Personal bankruptcy or creditor claims, so the other owners can buy an interest before a creditor takes control.
Insurance typically funds only the death and disability triggers. Retirement, divorce, and bankruptcy buyouts are usually funded through installment payments, company reserves, or outside financing. The buy-sell agreement should specify the funding mechanism for each trigger separately.
Key Person Insurance Is a Different Product
Buy-sell insurance and key person insurance solve different problems, and confusing them is a common planning mistake. Buy-sell insurance funds the ownership transfer. Key person insurance compensates the business for the financial hit of losing someone critical to operations, whether that’s the founder, top salesperson, or a technical expert who can’t be easily replaced. The business owns the key person policy and uses the proceeds to cover lost revenue, recruit a replacement, stabilize cash flow, or reassure creditors during the transition. A business with two co-owners who are both operationally critical may need both types of coverage, and the policies should be sized independently.
Applying for Coverage
The application requires documents from the business and each insured owner. Expect the carrier to ask for recent financial statements, including income statements and balance sheets, along with the federal employer identification number. A draft or executed copy of the buy-sell agreement is needed to establish the insurable interest and justify the requested coverage amount. The valuation figure from the agreement sets the face amount of the policy.
Each owner goes through individual medical underwriting. A paramedical examiner typically visits the applicant’s home or office at the insurer’s expense to draw blood, check blood pressure, and record height and weight. The insurer reviews medical records and may run a motor vehicle report. The full process usually takes four to eight weeks, though complex medical histories can stretch that timeline.
Coverage officially begins only after the underwriter approves the risk, the carrier issues the policy documents, and the first premium is processed. Signed delivery receipts must be returned to the insurer. Until all of those steps are complete, the buy-sell agreement is unfunded unless a conditional receipt from the insurer provides interim coverage. Ask the broker whether that option is available and what conditions apply.