A buy-sell agreement is a binding contract among the co-owners of a business that controls what happens to an ownership interest when one of them dies, becomes disabled, retires, divorces, goes bankrupt, or otherwise leaves the company. It names who is allowed to buy the departing owner’s share, sets the price or the method for determining it, and identifies where the money will come from. Get the structure wrong and you can trigger millions in unexpected estate tax, saddle surviving owners with a buyout obligation they cannot fund, or hand equity to an ex-spouse or heir who has no role in the business.
The Three Structures
Every buy-sell agreement is built around one mechanical question: who actually buys the departing owner’s interest? The answer drives almost everything else about taxes, insurance, and complexity.
Cross-Purchase
The remaining owners personally buy the departing owner’s share. If a three-owner company loses one member, the other two purchase portions of that person’s interest directly. The tax advantage is real: each surviving owner’s cost basis in the company increases by the amount they pay, which reduces capital gains if they later sell.
The drawback is logistical. Each owner typically holds a life insurance policy on every other owner, so the number of policies multiplies fast. A company with four owners needs twelve separate policies. Past three or four partners, the arrangement gets expensive and administratively messy.
Entity-Redemption
The company itself buys back the departing owner’s shares. Only one buyer is involved regardless of how many owners exist, which simplifies the mechanics. For a corporation, the redemption must satisfy IRC Section 302 to be taxed as a sale rather than a dividend. The most common qualifying path is a complete termination of the departing shareholder’s interest, though a redemption may also qualify if it is substantially disproportionate (the shareholder’s voting power drops below 80 percent of their pre-redemption ratio) or is not essentially equivalent to a dividend under the facts.1Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock
The tradeoff: surviving owners generally get no basis increase after a redemption. The company spent its money, not theirs, so their basis stays put. That can mean a larger capital gains bill later. Partnerships and S corporations have some exceptions that may allow a basis increase, but they require careful tax elections.2NAEPC Journal of Estate and Tax Planning. Options to Prevent a Connelly Outcome
Wait-and-See Hybrid
A hybrid defers the choice until a trigger actually happens. Typically the company gets the first option to redeem some or all of the departing owner’s shares. Any shares it does not redeem become available for the surviving owners to buy individually. Whatever remains must be picked up by the company. The layered order lets the parties choose the most tax-efficient path at the time rather than locking in a structure years in advance.
Tax Consequences That Should Drive the Structure Choice
Picking a structure is really a tax decision. Four issues catch owners off guard most often.
The Connelly Decision on Corporate-Owned Life Insurance
The 2024 Supreme Court decision in Connelly v. United States is the most significant development in buy-sell planning in decades, and anyone using an entity-redemption structure needs to understand it. Two brothers owned Crown C Supply. The company held $3.5 million in life insurance on each brother to fund a mandatory redemption at death. When one brother died, the surviving brother’s estate argued the company was worth about $3.86 million, excluding the insurance proceeds earmarked for the buyout. The IRS said the company was worth $6.86 million because the insurance proceeds were a corporate asset at the moment of death.3Supreme Court of the United States. Connelly v. United States, No. 23-146
The Court sided with the IRS. The insurance money belonged to the corporation, so it increased the corporation’s fair market value, which in turn inflated the value of the deceased owner’s shares for estate tax. The company’s obligation to spend those proceeds on the redemption did not offset the added value. The estate ended up taxed on $5.3 million of stock instead of $3 million.
The practical takeaway is blunt. If your buy-sell uses an entity-redemption structure funded with life insurance, the insurance proceeds will inflate the estate tax value of the deceased owner’s shares. Cross-purchase agreements avoid the problem because the policies are owned by the individual co-owners, so the proceeds never sit on the corporate balance sheet.
Basis Step-Up
Cross-purchase buyers get a dollar-for-dollar basis increase. Pay $500,000 for a deceased partner’s share, and your basis goes up by $500,000. In an entity redemption, the company writes the check, and the surviving owners’ basis stays where it was. Over a career of appreciation, that difference can be substantial.
Transfer-for-Value Trap
Life insurance death benefits are normally received income tax-free.4Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits That exclusion disappears if a policy is transferred to a new owner for valuable consideration. Under IRC Section 101(a)(2), the death benefit becomes taxable to the extent it exceeds what the new owner paid for the policy plus later premiums.
Exceptions preserve the tax-free treatment for a transfer 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. There is a conspicuous gap: a transfer to a fellow shareholder who is not a partner is not protected. That matters when a corporation with entity-owned policies tries to convert to a cross-purchase after Connelly. Reassigning those policies to individual shareholders can turn millions of dollars of tax-free proceeds into taxable income. Partnerships have more room because the partner exception covers most transfers.
Accumulated Earnings Tax
Corporations that build cash reserves to self-fund a future redemption face a 20 percent accumulated earnings tax on earnings retained beyond the reasonable needs of the business.5Office of the Law Revision Counsel. 26 USC 531 – Imposition of Accumulated Earnings Tax Most corporations can accumulate up to $250,000 without scrutiny, or $150,000 for personal service corporations in fields like law, accounting, health, and consulting.6Office of the Law Revision Counsel. 26 USC 535 – Accumulated Taxable Income Earmarking cash for a buy-sell obligation can qualify as a reasonable business need, but the corporation must document specific, definite, and feasible plans. A vague someday intention is not enough. A board resolution tying the accumulation to the buy-sell’s funding requirements is the safer path.
Trigger Events
The agreement sits dormant until a listed event activates it. Which events you include decides whether the contract does anything useful when trouble arrives.
Death is the universal trigger. The surviving owners or the entity must purchase the deceased owner’s shares from the estate, keeping the business out of probate fights and preventing uninvolved heirs from becoming co-owners.
Disability triggers work similarly but need careful definition. Specify what qualifies (typically the inability to perform duties for a continuous period of 12 to 18 months) and who decides. Vague disability language is one of the most litigated pieces of any buy-sell.
Retirement and voluntary withdrawal provisions handle planned departures. They usually set a notice period and allow installment payments rather than a lump sum. Without them, an owner can walk away with equity intact while contributing nothing.
Involuntary events are the ones owners most often forget. Personal bankruptcy can expose the business to creditor claims against an owner’s interest. A divorce can transfer part of the business to an ex-spouse through a property settlement. Listing both as mandatory buyout triggers keeps ownership with the people running the company.
Not every trigger has to force a sale. A right of first refusal gives existing owners the option to match an outside offer before an owner can sell to a third party. Most well-drafted agreements combine both approaches: mandatory buyouts for events like death and bankruptcy, and a right of first refusal for voluntary sales.
Setting the Price
The price paid for a departing owner’s interest is the most contentious element of any buy-sell. Three methods dominate.
Under a fixed-price method, the owners agree on a dollar value, typically reviewed and updated annually. Simple and certain, but neglected almost universally over time. A well-drafted agreement includes a fallback that switches to a formula or appraisal if the fixed price has not been updated within a set period, often two years.
A formula ties the price to a financial metric: a multiple of average net income or EBITDA, or a percentage of book value. It adjusts automatically but can produce odd results in an unusual year. Choosing the metric and averaging period matters more than the formula itself.
An independent appraisal at the time of the trigger produces the most accurate number but is also the most expensive and slowest. Appraisals for small to mid-sized businesses commonly cost between $2,000 and $10,000. Any competent appraiser will follow the Revenue Ruling 59-60 framework the IRS uses for valuing closely held stock.
For estate tax purposes, the price the agreement sets will only be respected by the IRS if the agreement meets three conditions from Connelly: it must be a bona fide business arrangement, it cannot be a device to transfer property to family members at a discount, and its terms must resemble what unrelated parties would agree to at arm’s length.3Supreme Court of the United States. Connelly v. United States, No. 23-146
Funding the Buyout
An agreement nobody can afford to honor is worse than none at all. The funding mechanism is what turns a plan into a real one.
Life insurance is the most common funding tool because it delivers cash exactly when a death trigger fires. Proceeds paid by reason of the insured’s death are excluded from gross income under IRC Section 101(a).4Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits Premiums are not deductible. In a cross-purchase, each owner buys a policy on every other owner and pays the premiums personally. In a redemption, the company owns the policies and pays. After Connelly, owners with estates near the federal estate tax threshold should think hard about a cross-purchase or hybrid structure to keep insurance off the corporate balance sheet.
Disability buyout insurance covers the non-death triggers that life insurance misses. These policies impose an elimination period of 12 to 18 months of continuous disability before benefits begin, then pay out as a lump sum or in installments. The elimination period in the policy should match the disability definition in the agreement so there is no gap between when the buyout is triggered and when the money arrives.
Sinking funds are straightforward but carry two risks. A trigger event can happen before the fund is large enough, and corporations that accumulate cash face the accumulated earnings tax discussed above. Documenting the business purpose and keeping the balance proportional to the expected obligation are essential.
Installment notes fill the gap when cash or insurance falls short. The buyer pays the departing owner or their estate over time. The interest rate must meet or exceed the IRS Applicable Federal Rate to avoid the imputed interest rules under IRC Section 7872.7Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates As of January 2026, the AFR ranges from 3.63 percent for short-term to 4.63 percent for long-term loans.8Internal Revenue Service. Revenue Ruling 2026-2 – Applicable Federal Rates Charging below the AFR generates phantom income for the lender and can recharacterize part of the transaction as a gift. Terms of five to ten years are common, and the agreement should spell out what happens on default: acceleration, share reclamation, or a penalty interest rate.
Bank loans and SBA-backed financing can fill remaining gaps, but lenders evaluate the company at the time of the trigger event, which is often the worst possible moment. A pre-approved credit facility or an established banking relationship makes external financing more realistic.
When the Money Isn’t There
An unfunded buy-sell creates a breach of contract the moment the trigger fires and nobody can pay. The departing owner or their estate can sue for specific performance, forcing the remaining owners to find the money and complete the purchase. If performance is impossible, the estate can sue for damages equal to the unpaid buyout price. In some cases the governing documents require dissolution when neither the entity nor the surviving owners can complete the purchase, and courts have enforced that remedy. An agreement without realistic funding is a liability, not a protection.
Spousal Consent in Community Property States
In community property states, a business interest acquired during marriage is presumed jointly owned by both spouses. An owner’s spouse may have a legal claim to the shares the agreement covers. Without a spousal consent or waiver, the transfer restrictions may not be enforceable against the non-signing spouse. The states where this comes up are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Getting consent at signing is far easier than getting it during a divorce. The consent form has the spouse acknowledge the terms and waive any community property claims that would conflict with the buyout. Separate counsel for the consenting spouse is advisable. If the spouse refuses to sign, the transfer restrictions may be worthless later.
Drafting Inputs and Review Cadence
A workable agreement requires more than structural choices. Document every owner’s full legal name, tax identification number, and current ownership percentage. Identify the valuation method, the funding mechanism, any insurance policy numbers, and the accounts or escrow arrangements holding funds.
Corporate entities usually need a board resolution or shareholder vote to adopt the agreement. LLCs may need an operating agreement amendment or unanimous member consent, depending on the governing documents. Some charters impose supermajority voting for transactions this significant. Skipping those formalities can render the whole agreement unenforceable.
Legal fees for a customized agreement typically run between $750 and $1,200, with more for complex multi-owner structures that include tax planning. Review the agreement whenever something material changes: a new owner joins, an owner’s family situation shifts, the company’s value moves meaningfully, or the tax rules move (as they did with Connelly). An agreement drafted years ago and never revisited is almost always a problem waiting to happen.