Buy-Sell Agreement Life Insurance: Tax, Basis, and Estate Issues

Life insurance premiums that fund a buy-sell agreement are not tax-deductible, and the death benefit generally arrives free of income tax, which is what makes life insurance the standard funding tool for these agreements. The buy-sell agreement life insurance tax implications that actually decide whether the arrangement works, though, sit further downstream: whether the surviving owners get a cost basis increase in the shares they acquire, whether the deceased owner’s estate ends up with a larger tax bill because of the insurance itself, and whether a missing consent form quietly converts a tax-free payout into ordinary income. A 2024 Supreme Court decision made one of those questions considerably more urgent for companies that own the policies themselves.

Premiums Are Not Deductible

IRC Section 264(a)(1) denies a deduction for premiums on any life insurance policy where the taxpayer is directly or indirectly a beneficiary.¹ That covers every common buy-sell structure. In a cross-purchase arrangement, each owner personally holds policies on the other owners and cannot deduct the premiums. In an entity-purchase arrangement, the business owns the policies and cannot deduct them either.

Every premium dollar comes out of after-tax money, and over a 20- or 30-year policy term, the nondeductible cost is meaningful. It belongs in the cash-flow analysis when the coverage amount and policy type are chosen. Whole life and universal life policies build cash value, but the annual premium payments themselves never reduce taxable income.

The Death Benefit Is Income-Tax-Free, With One Serious Catch

When the insured owner dies, IRC Section 101(a)(1) excludes the death benefit from gross income.² A $3 million policy pays $3 million, and neither the surviving owners nor the business owes income tax on the proceeds. That exclusion is the reason the whole structure works.

Entity-owned policies carry a compliance trap. IRC Section 101(j) applies to any life insurance contract owned by a business on the life of an employee. If the business does not meet the notice and consent requirements before the policy is issued, the income tax exclusion collapses to the amount of premiums the business paid; everything above that becomes taxable ordinary income.²

Three things have to happen in writing before the policy takes effect:³

The employee must be told that the business intends to insure their life and given the maximum face amount the policy could carry.
The employee must consent to being insured and acknowledge that coverage may continue after they leave the company.
The employee must be informed that the business will be a beneficiary of the proceeds.

The dollars at stake are large. On a $5 million policy where the business paid $400,000 in premiums, missing Section 101(j) turns $4.6 million into taxable ordinary income. At the top 2026 federal rate of 37%, that is roughly $1.7 million in unexpected tax, and the business is left well short of the funds it needed to complete the buyout.⁴ Most entity-purchase plans that fail here fail on paperwork, not on structure.

The Transfer-for-Value Rule

Whenever a life insurance policy is transferred for money or other valuable consideration, IRC Section 101(a)(2) strips away most of the income tax exclusion. The new owner can exclude only what they paid for the policy plus any premiums they subsequently paid; the rest of the death benefit is taxable when the insured dies.²

Buy-sell agreements often need to move policies. A new partner joins and takes over an existing policy. The business converts from a cross-purchase to an entity-purchase structure. A retiring owner sells the policy on a remaining partner to the company. Any of these transfers can trip the rule.

The statute lists exceptions. The rule does not apply when the policy is transferred to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is a shareholder or officer, or to a transferee whose basis is determined by reference to the transferor’s basis.

The partner exception is why partnerships are often the friendlier vehicle for cross-purchase agreements: a policy on Partner A can be transferred to Partner B without a problem, because Partner B is a partner of the insured. Corporations do not get the same flexibility. Transferring a policy between two shareholders of a C corporation fits no exception, and part of the death benefit becomes taxable.² Businesses that change entity type without reviewing their policies frequently walk into this problem years after the fact.

Structure Decides the Cost Basis

The choice between a cross-purchase and an entity-purchase agreement determines how much tax the surviving owners will pay when they eventually sell the business. The difference can run into hundreds of thousands of dollars.

Cross-Purchase Agreements

In a cross-purchase, each owner personally holds policies on the other owners. When one owner dies, the survivors collect the tax-free proceeds and use that cash to buy the deceased owner’s interest directly from the estate. Because they are buying shares with their own money, their cost basis in the company goes up by the full purchase price.²

Consider two equal partners in a $4 million company. Partner A dies. Partner B collects $2 million in insurance and pays $2 million to Partner A’s estate for the shares. Partner B’s basis rises by $2 million. If Partner B later sells the company for $6 million, that basis increase reduces the taxable gain, and at the 20% long-term capital gains rate it can save $400,000 in federal tax on its own.⁵ Passive owners may also face the 3.8% net investment income tax on the same gain, which makes the basis step-up even more valuable.

The downside of a cross-purchase is administrative. The number of policies grows with the number of owners, and the policy web has to be reconfigured every time someone joins or leaves. A trusteed cross-purchase arrangement uses a third-party trustee to hold one policy per owner while preserving the basis advantage for each surviving owner.

Entity-Purchase (Redemption) Agreements

In an entity-purchase agreement, the business owns the policies, collects the proceeds, and redeems the deceased owner’s shares. The surviving owners buy nothing. Their percentage of the company goes up because fewer shares are outstanding, but their cost basis in their original shares does not change.

Take the same two partners and the same $4 million company. Partner A dies. The company collects $2 million and redeems Partner A’s shares. Partner B now owns 100% of the company, but Partner B’s basis is still whatever was originally invested. When Partner B eventually sells for $6 million, the full difference between $6 million and that original basis is taxable. The $2 million the company spent to redeem the shares gives Partner B no basis credit.

Entity-purchase agreements stay popular because they are simpler to run: one policy per owner, managed by the company, no exploding policy count. The trade-off in future capital gains tax is real, and the Supreme Court has made the estate tax side worse.

S Corporation Basis Adjustments

S corporations pass items through to shareholders, and IRC Section 1367 requires each shareholder’s stock basis to be adjusted for those items year by year. Tax-exempt income received by the corporation, including a life insurance death benefit, increases each shareholder’s basis; non-deductible expenses, including life insurance premiums, decrease it.⁶

In an S corporation with an entity-purchase buy-sell, nondeductible premium payments reduce each shareholder’s basis annually, and the tax-free death benefit increases the surviving shareholders’ basis when it is received. Because the death benefit typically dwarfs cumulative premiums, the net basis increase at death is meaningful. Shareholders need to track these adjustments year by year to avoid a surprise at sale time.

Estate Tax Consequences

The federal estate tax applies to estates exceeding $15,000,000 per individual in 2026.⁷ Business owners often assume their estate falls comfortably below that threshold, but life insurance proceeds can push it over, particularly when the policy is structured poorly.

Incidents of Ownership

If the deceased owner held any “incidents of ownership” in a policy on their own life, IRC Section 2042 pulls the full death benefit into the taxable estate.⁸ Incidents of ownership are defined broadly, including the power to change the beneficiary, cancel or surrender the policy, assign it, pledge it as collateral, or borrow against the cash value.⁹

A properly executed cross-purchase avoids the issue because the deceased owner never held the policies on their own life. An entity-purchase arrangement generally avoids it too, because the corporation is the owner. Problems appear when the paperwork is sloppy: a partner who was supposed to transfer ownership but never did, or a controlling shareholder the IRS argues had indirect control over corporate-owned policies.

Valuation Under Section 2703

The IRS does not automatically accept the buy-sell price as the fair market value of the deceased owner’s interest. Under IRC Section 2703, the agreement’s price is disregarded for estate tax purposes unless it meets three tests: it must be a genuine business arrangement, it cannot be a device to transfer the interest to family members for less than full value, and its terms must be comparable to what unrelated parties would agree to at arm’s length.

Stale valuations are the common failure. An agreement drafted when the company was worth $2 million goes untouched while the business grows to $10 million. The estate is shortchanged on the buyout price, and the IRS can still assess estate tax on the actual $10 million value. Regular appraisals, updated every few years or after any major business event, keep the buyout price defensible.

Connelly v. United States

In June 2024, the Supreme Court decided Connelly v. United States and changed the estate tax picture for entity-purchase agreements funded with life insurance. The Court held that life insurance proceeds payable to a corporation are a corporate asset that increases the company’s fair market value for estate tax purposes, and that the corporation’s obligation to redeem the deceased owner’s shares does not offset that increase.¹⁰

The practical result is uncomfortable. Buying more insurance to fully fund a redemption inflates the company’s value, which inflates the deceased owner’s estate, which increases the estate tax, which increases the funding gap the insurance was supposed to close. Cross-purchase agreements sidestep the problem because the insurance proceeds are received by the individual owners, not the company, and never enter the corporate valuation. For businesses currently using an entity-purchase structure funded with life insurance, Connelly is a direct prompt to review the arrangement.

Annual Form 8925 Reporting

Businesses that own life insurance on employees have an annual filing obligation. IRS Form 8925 requires employers to report the number of employees covered by employer-owned life insurance contracts issued after August 17, 2006, and the total coverage in force at year end.¹¹ Policies held under entity-purchase buy-sell agreements are included when the covered owners are also employees.

The larger risk around Form 8925 is not the form itself but what an audit uncovers alongside it. If the annual filing was never made, the natural next question is whether the Section 101(j) notice and consent paperwork was ever completed, and that is where the real money is at stake. Treating the Form 8925 filing as a yearly checkpoint to verify that consent documentation is current and properly stored protects the income tax exclusion on the eventual death benefit.

Matching the Structure to the Tax Result You Want

Every structural choice carries a trade-off. Cross-purchase agreements give surviving owners a basis increase that saves real money on a future sale and keep the death benefit out of the deceased owner’s estate valuation, but they require more policies and more administration, especially with four or more owners. Entity-purchase agreements are simpler to run but leave surviving owners with no basis adjustment, and after Connelly they can inflate the deceased owner’s estate by the full amount of the proceeds.

A “wait-and-see” hybrid lets the parties decide at the time of an owner’s death whether the entity or the surviving owners will purchase the interest. That preserves flexibility, but it introduces uncertainty about basis treatment and requires careful drafting to avoid the transfer-for-value rule. A trusteed cross-purchase can deliver the tax advantages of cross-purchase with much of the administrative simplicity of entity-purchase.

Whatever structure is chosen, three compliance items protect the tax benefits: complete the Section 101(j) notice and consent paperwork before any policy is issued, file Form 8925 every year, and update the agreement’s valuation regularly so the buyout price will hold up if the IRS looks at it. The tax code rewards businesses that handle these details in advance and punishes those that don’t, often at six or seven figures.

1
Office of the Law Revision Counsel. 26 U.S. Code 264 – Certain Amounts Paid in Connection With Insurance Contracts
2
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
3
Office of the Law Revision Counsel. 26 U.S. Code 101 – Certain Death Benefits
4
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
5
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
6
Office of the Law Revision Counsel. 26 U.S. Code 1367 – Adjustments to Basis of Stock of Shareholders
7
Internal Revenue Service. Estate Tax
8
Office of the Law Revision Counsel. 26 U.S. Code 2042 – Proceeds of Life Insurance
9
eCFR. 26 CFR 20.2042-1 – Proceeds of Life Insurance
10
Supreme Court of the United States. Connelly v. United States, No. 23-146
11
Internal Revenue Service. About Form 8925, Report of Employer-Owned Life Insurance Contracts