A buy-sell agreement funded with life insurance gives business co-owners a plan for transferring ownership if a partner dies, becomes disabled, or leaves the company. Life insurance provides immediate, tax-free cash so surviving owners can buy out the departing partner’s share without draining the business.
If you co-own a business, you need a plan for what happens when a partner dies, retires, or can’t work anymore. Without one, your surviving partners could face a legal mess, family disputes, and a cash crunch that threatens the company’s future.
That’s where a buy-sell agreement comes in. Funded by life insurance, it gives your business the money it needs to buy out a departing owner’s share, on terms everyone agreed to in advance. Think of it as a business prenup. It protects your partners, your family, and your company.
This guide covers how buy-sell agreements work, the three main types, how life insurance funds them, and a recent Supreme Court ruling every business owner should know about.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract between business owners. It spells out what happens to an owner’s share of the business when a triggering event occurs.
These triggering events typically include:
- Death of an owner
- Permanent disability that prevents an owner from working
- Retirement of an owner
- Divorce (to prevent a spouse from gaining ownership)
- Bankruptcy of an individual owner
- Voluntary departure when an owner wants to leave
The agreement sets the terms for buying out the departing owner’s interest, including the purchase price, payment method, and timeline. Without it, surviving owners may be forced into business with an heir, ex-spouse, or creditor they never planned to work with.
A buy-sell agreement is different from key man life insurance, which protects a business from the financial loss of a key employee. A buy-sell agreement specifically handles the transfer of ownership.
Three Types of Buy-Sell Agreements
There are three main structures for a buy-sell agreement. The right one depends on the number of owners and your tax situation.
Cross-Purchase Agreement
Each owner buys a life insurance policy on the other owners. When one owner dies, the surviving owners collect the death benefits and use that money to buy the deceased owner’s share.
This works best for businesses with two or three owners. With more partners, the number of policies gets complicated fast. The formula is N x (N-1), where N is the number of owners. Two owners need 2 policies. Three owners need 6. Four owners need 12.
Entity Redemption Agreement
The business itself owns life insurance policies on each owner. When an owner dies, the company collects the death benefit and buys back the deceased owner’s share.
This is simpler for businesses with multiple owners because the company only needs one policy per owner. The trade-off is that the surviving owners don’t get a step-up in their cost basis, which can mean higher capital gains taxes later.
Wait-and-See (Hybrid) Agreement
This combines both approaches. The agreement gives the surviving owners the first option to buy the deceased partner’s share (cross-purchase). If they decline, the business buys it instead (entity redemption).
A hybrid agreement gives you flexibility to choose the best tax outcome at the time of the triggering event.
Comparing the Three Types
| Feature | Cross-Purchase | Entity Redemption | Wait-and-See |
|---|---|---|---|
| Who buys the policies | Each owner | The business | Both (flexible) |
| Best for | 2-3 owners | 4+ owners | Any number |
| Cost basis step-up | Yes | No | Depends on method used |
| Policies needed (3 owners) | 6 | 3 | Varies |
| Complexity | Higher with more owners | Simpler | Most complex |
Why Life Insurance Is the Best Funding Method
You can fund a buy-sell agreement with cash reserves, installment payments, or a bank loan. But life insurance is the most common and practical choice for several reasons.
Advantages:
- Provides an immediate lump sum of cash at death
- Death benefit proceeds are generally income tax-free
- Settles the buyout quickly, often within weeks
- Premiums are far less than the payout, especially for younger, healthy owners
- Term life insurance keeps costs low for agreements tied to a specific time period
Disadvantages:
- Premiums are paid with after-tax dollars (not tax-deductible)
- An owner with serious health issues may face higher premiums or be denied coverage
- Age differences between partners can create unequal premium costs
- Policies need to be reviewed and updated as business values change
For most small businesses, term life insurance is the best fit. It’s affordable, and you can match the policy length to your business timeline or partnership agreement.
The Connelly Ruling: What Business Owners Need to Know
In June 2024, the U.S. Supreme Court issued a unanimous decision in Connelly v. United States that changed how entity redemption agreements are taxed.
The court ruled that life insurance proceeds received by a company to fund an entity redemption buy-sell agreement count as a corporate asset for estate tax purposes. This means the deceased owner’s share of the business is worth more on paper, which can increase the estate tax bill for their heirs.
This ruling makes cross-purchase agreements more attractive from a tax standpoint because the life insurance is owned by individuals, not the company. If your business currently uses an entity redemption plan, it’s worth consulting with a tax attorney to review your agreement.
How Much Coverage Do You Need?
The life insurance coverage for each owner should match the value of their ownership interest. To determine that number, you’ll need a current business valuation.
Common valuation methods include:
- Agreed-upon value set by all owners and reviewed annually
- Formula-based using a multiple of revenue or earnings
- Independent appraisal by a certified business valuator
The key is to review and update the valuation regularly. A business valued at $500,000 five years ago may be worth much more or less today. Outdated valuations create problems for everyone involved.
Frequently Asked Questions
What type of life insurance is best for a buy-sell agreement?
Term life insurance is the most common and affordable choice for funding a buy-sell agreement. It works well when the agreement covers a set period, like the active years of a partnership. If you need lifetime coverage or want to build cash value, permanent life insurance is an option, but it costs significantly more.
Can a buy-sell agreement cover disability, not just death?
Yes. Many buy-sell agreements include disability as a triggering event. You can add a disability buy-out insurance policy to fund the purchase of a disabled owner’s share. This protects both the business and the owner’s family if a partner can no longer work.
How does the Connelly ruling affect my buy-sell agreement?
The 2024 Connelly v. United States ruling means life insurance proceeds held by a company under an entity redemption plan now count as a corporate asset for estate tax purposes. This can increase the taxable value of a deceased owner’s share. Business owners using entity redemption plans should review their agreements with a tax attorney.
How often should a buy-sell agreement be reviewed?
Review your buy-sell agreement at least once a year or whenever there’s a major change, like a new partner joining, an owner leaving, or a significant shift in business value. The life insurance coverage amounts should be updated to reflect the current value of each owner’s interest.
Are life insurance premiums for a buy-sell agreement tax-deductible?
No. Life insurance premiums used to fund a buy-sell agreement are not tax-deductible, whether paid by the business or individual owners. The trade-off is that the death benefit proceeds are generally received income tax-free.
Key Takeaways
- A buy-sell agreement is a legally binding contract that protects your business when an owner dies, becomes disabled, or leaves.
- There are three types: cross-purchase, entity redemption, and wait-and-see (hybrid).
- Life insurance is the most practical way to fund a buy-sell agreement because it provides immediate, tax-free cash.
- The 2024 Connelly v. United States ruling makes cross-purchase agreements more tax-favorable than entity redemption plans for estate tax purposes.
- Term life insurance is the most affordable option for most buy-sell agreements.
- Review your agreement and coverage amounts at least once a year as business values change.
- Work with a business attorney and insurance professional to set up the right structure.
Ready to find the right term life insurance for your buy-sell agreement? Use the life insurance quoter on this page to compare rates from top-rated carriers, or call us at 800-712-8519 for a free consultation. We’ll help you find the right coverage to protect your business and your partners.
