How to Structure a Buy-Sell Agreement: The Tax and Insurance Components Explained

A buy-sell agreement is a binding contract governing what happens to a co-owner's business interest when they die, become disabled, retire, or otherwise exit. Without one, surviving partners can be forced into involuntary co-ownership with the departing partner's heirs — people with legal rights but no operational role. For CPAs, the agreement is a tax planning document: the chosen structure determines who receives a stepped-up cost basis, whether the estate owes additional taxes, and how the transaction is treated at each entity level. For insurance brokers, adequate and correctly owned funding is the linchpin — an underfunded buy-sell collapses at the moment it matters most. Getting both right requires coordinating the structure across both disciplines before a triggering event occurs — and ideally, that coordination begins when the business is first formed. For the upstream conversation that sets the foundation for buy-sell planning, see How CPAs and Insurance Brokers Should Collaborate When a Client Starts a New Business.

A buy-sell agreement governs the ownership transfer mechanism — one component of a complete succession plan. For the full framework — exit route selection, valuation methodology, estate plan alignment, and the tax consequences of third-party sales, family transfers, and installment arrangements — see Business Succession Planning: How to Coordinate the Tax and Insurance Components.

Prerequisites

Entity formation documents for all entities in the ownership structure — operating agreements, shareholder agreements, and articles of incorporation
Current ownership percentages for all co-owners and each owner's health status, to assess life and disability insurance underwriting feasibility
Current or recent business valuation, or agreement on the valuation method to be used at triggering events
For S-Corp clients: each shareholder's stock basis, accumulated adjustments account (AAA) balance, and any outstanding shareholder loans
For C-Corp clients: accumulated earnings balance, any pending share repurchase activity, and estate plan documents for owners with potentially taxable estates
Each owner's existing insurance policies and broader estate plan, to identify coverage overlaps and gaps

Step 1: Choose the Agreement Structure

Two fundamental structures exist, and the choice permanently affects cost basis, estate tax exposure, and administrative complexity.

Cross-purchase agreement: Each co-owner purchases a life insurance policy on every other owner's life. At the triggering event, surviving owners use the proceeds to buy the departing owner's interest directly — from the estate (at death) or from the owner directly (at disability, retirement, or departure). Each purchasing owner establishes a new cost basis in the acquired shares equal to the purchase price — locking in a stepped-up basis that reduces capital gain on a future business sale.

Entity redemption (stock redemption) agreement: The business itself purchases life insurance on each owner, collects the death benefit, and uses the proceeds to redeem the departing owner's interest. The remaining owners' equity percentages increase proportionally — but their basis in their original shares does not change. The stepped-up basis benefit flows to the estate of the departing owner, not to the survivors.

The Connelly ruling (2024): In Connelly v. United States, 602 U.S. ___ (2024), the Supreme Court held unanimously that life insurance proceeds held by a corporation to fund a stock redemption must be included in the corporation's fair market value for estate tax purposes. The proceeds are a corporate asset — not an offset to the redemption obligation. For clients with potentially taxable estates, entity redemption structures increase estate tax exposure at exactly the moment the buyout is funded. Cross-purchase structures avoid this entirely: policies owned individually by co-owners are not corporate assets and do not inflate the corporation's value at death.

Practical selection guidance: For two or three co-owners, cross-purchase typically provides the stronger tax outcome — stepped-up basis for surviving purchasers and Connelly avoidance. For four or more owners, administrative complexity increases substantially: ten owners in a full cross-purchase require 90 separate policies. A wait-and-see (hybrid) agreement — which preserves both structure options and elects the mechanism at the triggering event based on then-current facts — is practical for larger ownership groups. For entity type considerations that affect which structure is appropriate, see C-Corp vs S-Corp vs LLC: The Complete Entity Selection Guide for CPAs.

Step 2: Define the Triggering Events

A buy-sell agreement limited to death is incomplete. The triggering events section is where disputes most commonly originate.

Standard triggering events to address:

Death — most commonly funded; most straightforward in terms of insurance proceeds timing
Permanent disability — requires a precise contractual definition aligned with the disability buyout policy's terms (typically continuous inability to perform substantial duties for 12–24 months)
Voluntary retirement or withdrawal — often structured as an option for the entity or surviving owners, not a mandatory purchase obligation
Divorce — prevents an ex-spouse from acquiring an ownership interest and becoming an involuntary partner
Bankruptcy or creditor attachment — triggers the right to purchase before an outside party obtains the interest through legal process
Felony conviction — protects the business's reputation, professional licenses, and existing client relationships

For each triggering event, the agreement must specify: (1) whether the purchase is mandatory or optional, (2) who holds the first right to purchase (entity, co-owners in sequence, or third parties), and (3) which valuation mechanism applies. Mandatory purchase at death is generally appropriate; voluntary withdrawal may warrant only an option — so the business is not forced to fund a buyout whenever an owner wants liquidity.

Step 3: Establish the Valuation Method

Valuation disputes are the leading cause of buy-sell agreement litigation. The method must be specific enough to determine price without going to court.

Fixed price: Owners set a value at signing and update it annually in a written rider. Simple — but almost always outdated when the agreement triggers if annual updates are skipped. Require a board resolution or written agreement amendment confirming or revising the fixed price at every annual meeting.

Formula approach: Price is determined by a formula tied to financial results — typically a multiple of EBITDA, adjusted net income, or book value. Objective and self-updating; requires a precise definition of which financial statements govern the calculation, who prepares them, what adjustments apply, and who resolves disputes about the inputs.

Third-party appraisal: At the triggering event, an independent business valuation professional determines fair market value. Most accurate — but adds time and cost when speed matters. The agreement must specify the appraiser's minimum qualifications (typically a Certified Valuation Analyst or Accredited Business Valuator), the timeline for completing the appraisal, and the dispute resolution mechanism if the parties cannot agree on a single appraiser.

Estate tax binding effect under IRC §2703: A buy-sell agreement's price binds the IRS for estate tax valuation only if three conditions are met: the agreement must be a bona fide business arrangement (not a testamentary device), it must not be designed to transfer property to family members for less than adequate consideration, and its terms must be comparable to arrangements among unrelated parties transacting at arm's length. Family-owned business agreements that set below-market prices require particular care — an agreement that fails §2703 is disregarded for estate tax purposes, leaving the estate taxed at fair market value while the business receives the discounted buyout price.

Step 4: Fund the Agreement with Life and Disability Insurance

Life insurance is the most reliable buy-sell funding mechanism because it creates liquidity at the exact moment of need without depleting business cash reserves.

Life insurance sizing: The face amount should match the owner's current buyout value under the agreement's valuation method. Since business values change, policies must be reviewed annually and coverage increased when values outpace face amounts.

Premium deductibility (IRC §264(a)(1)): Life insurance premiums are not deductible when the taxpayer — whether an individual owner or the business entity — is a direct or indirect beneficiary of the policy. This applies equally to individually owned policies in cross-purchase structures and to corporate-owned policies in entity redemption structures. Premium non-deductibility is the tradeoff for income-tax-free death benefits under IRC §101(a).

Corporate-owned life insurance (COLI) consent requirements: Under IRC §101(j), employer-owned life insurance must satisfy written notice and consent requirements before the policy is issued. The employer must notify the employee in writing — before the policy is issued — that it will be insured, the maximum face amount, and that the employer will be a beneficiary. The employee must consent in writing. Failure to satisfy §101(j) means only the employer's cost basis in the policy is excluded from income; the excess death benefit above premiums paid is taxable at the corporate level.

Transfer-for-value rule (IRC §101(a)(2)): If a life insurance policy is transferred for valuable consideration, the death benefit becomes partially taxable — only the transferee's basis (premiums paid plus consideration transferred) is excluded from income. In a cross-purchase structure with multiple owners, policies that change hands when an owner exits can trigger this rule inadvertently. Recognized exceptions include transfers to a partner of the insured and transfers to a corporation in which the insured is a shareholder or officer. In an S-Corp context, shareholders are treated as partners for this purpose. Track all policy ownership changes carefully and verify exception availability before any transfer.

Disability buyout insurance: Disability is statistically more likely than premature death during active working years, yet disability buyout funding is routinely omitted from buy-sell planning. A disability buyout policy pays a lump sum or structured installments after the insured has been continuously and totally disabled for the elimination period — typically 12 to 24 months. Premiums are not deductible; the benefits received are generally income-tax-free when used to fund the buyout. The policy's disability definition must match the buy-sell agreement's disability trigger precisely — a mismatch between the two creates a gap where the agreement triggers but the insurance does not yet pay.

For companies with employees who are not co-owners — whose death or disability would cause significant financial harm without creating a buyout obligation — key person life and disability insurance addresses a distinct but complementary exposure. Both types of coverage operate under the same IRC §264(a)(1) premium non-deductibility rule and require §101(j) notice and consent documentation for employer-owned life policies.

Step 5: Coordinate the Tax Treatment by Entity Type

The entity structure at the time of the triggering event determines how the buyout is taxed for both the departing owner and the survivors.

S-Corp entity redemption: The S-Corp receives the life insurance death benefit income-tax-free under IRC §101(a) and uses it to redeem the deceased shareholder's stock. The estate receives the S-Corp shares with a stepped-up basis under IRC §1014, making the redemption generally income-tax-free for the estate. The surviving shareholders' stock basis does not increase. If the S-Corp has IRC §1374 built-in gains from a prior C-Corp conversion, a redemption that causes a constructive asset sale during the recognition period can accelerate built-in gains tax.

S-Corp cross-purchase: Surviving shareholders purchase the deceased owner's stock using individually owned insurance proceeds. Each purchasing shareholder establishes basis in the acquired shares equal to the purchase price — protecting against capital gain on a future business sale. The S-Corp's accumulated adjustments account is unaffected by a cross-purchase.

C-Corp entity redemption: As established in Connelly v. United States (2024), life insurance proceeds held by the corporation must be included in the company's FMV for estate tax purposes. For C-Corp clients with potentially taxable estates, a cross-purchase structure — where policies are owned by individual co-shareholders rather than the corporation — avoids the Connelly problem. For C-Corp clients with QSBS-eligible stock, cross-purchase structures also require careful analysis: shares acquired in a cross-purchase are purchased from a selling shareholder, not issued by the corporation, and therefore do not qualify as original-issue QSBS under IRC §1202(c)(1)(B). See QSBS Guide 2025: How to Qualify for the IRC §1202 Gain Exclusion Under OBBBA for the original-issuance requirements and how buy-sell ownership transfers interact with QSBS eligibility.

LLC/partnership: Buy-sell payments in a partnership are analyzed under IRC §736. Payments allocable to the partner's share of unrealized receivables — and, absent a specific agreement provision, goodwill — are ordinary income to the retiring partner under IRC §736(a). Payments for the partner's share of other assets, including stated goodwill where the agreement so specifies, receive capital gain treatment under IRC §736(b). In high-goodwill professional service firms — law partnerships, accounting firms, consulting practices — the agreement's treatment of goodwill is a material tax decision that belongs in the drafting discussion.

Holding company structures: When a buy-sell applies to interests in a holding company that itself owns operating subsidiaries, the entity type at the holding company level governs the tax treatment, and the ownership structure at each layer must be mapped before the buy-sell is drafted. See Holding Company Structures for Business Clients: When and How to Recommend One for how entity type at the holding company level affects ownership transfer mechanics and inter-entity tax treatment.

Step 6: Review and Maintain the Agreement

A buy-sell agreement is only as functional as its most recent review.

Annual review checklist:

Has business value changed materially? Update the fixed price or verify the formula's current output.
Has insurance coverage kept pace with the updated valuation? Are any policies underperforming or approaching lapse?
Has ownership changed? New co-owners must be added to the agreement; departing owners' policies must be resolved without triggering the transfer-for-value rule.
Have any owners' health, estate plans, or family circumstances changed in ways that affect the agreement's terms or insurance underwritability?
Have tax law changes — including Connelly and OBBBA estate tax provisions — created a reason to revisit the chosen structure?

The review requires input from both the CPA — who understands the tax and basis implications — and the insurance broker, who tracks coverage adequacy, policy performance, and carrier solvency. Neither professional has full visibility into the other's exposure: a CPA may identify a basis problem without recognizing the coverage gap that generates it; a broker may update coverage limits without understanding the Connelly implications of the current structure. Arvori connects CPAs and insurance brokers in a shared workflow so buy-sell reviews surface both types of issues in the same conversation.

Common Mistakes

Policy ownership mismatches the agreement structure. A cross-purchase agreement with policies owned by the corporation creates a structural mismatch — the entity holds policies it cannot use to fund a cross-purchase without first distributing the proceeds (which may create a taxable event at the corporate level before the buyout even begins). Verify that policy ownership aligns with the agreement's structure at signing and at every subsequent review.

Ignoring the disability trigger. An agreement that lists disability as a triggering event but carries only life insurance leaves the disability buyout unfunded. The surviving owners must operate the business while a disabled co-owner remains on title — and potentially on salary — for the duration of the elimination period without a funded mechanism to resolve the ownership.

Setting a fixed price and skipping annual updates. A business worth $1 million at agreement signing that has grown to $4 million when the agreement triggers has effectively pre-sold the interest at a 75% discount. The estate receives the contractual price; the estate tax is generally owed on fair market value (subject to the §2703 binding-effect test). The estate bears the spread between the two.

Overlooking the transfer-for-value rule in multi-owner cross-purchases. When an owner departs and remaining owners need to redistribute that departing owner's policies, transferring policies between owners for consideration can trigger the transfer-for-value rule and make the death benefit partially taxable. Structure initial policy ownership to avoid requiring later transfers, or verify that a recognized statutory exception — such as the partner exception under IRC §101(a)(2)(B) — applies.

Not addressing QSBS impact in C-Corp cross-purchases. Surviving co-owners who acquire shares through a cross-purchase receive a secondary-market purchase from the selling shareholder — not an original issuance from the corporation. Those acquired shares are generally not qualifying QSBS under §1202(c)(1)(B). For C-Corp clients with substantial unrealized QSBS gain, the choice of buy-sell structure warrants explicit QSBS eligibility analysis before the agreement is executed.

Frequently Asked Questions

What is the difference between a cross-purchase and a stock redemption buy-sell agreement?

In a cross-purchase agreement, co-owners buy each other's interests directly — each surviving owner pays fair market value for the acquired shares, establishing a new stepped-up cost basis that reduces capital gain on a future sale. In a stock redemption agreement, the business itself redeems the departing owner's interest — surviving owners' equity increases proportionally, but their basis in their original shares does not change. The 2024 Connelly ruling added a significant estate tax disadvantage to the entity redemption structure for corporate entities: life insurance proceeds held by the corporation are included in the company's fair market value for estate tax purposes, increasing the estate's tax exposure at death.

Is the life insurance premium deductible when funding a buy-sell?

No. Under IRC §264(a)(1), premiums paid on life insurance policies are not deductible when the policyholder or beneficiary is directly or indirectly the beneficiary of the policy. This applies to individually owned policies in a cross-purchase structure and to corporate-owned policies in an entity redemption structure. The tradeoff is income-tax-free death benefits under IRC §101(a) — the tax treatment that makes life insurance the economically superior funding mechanism.

What did Connelly v. United States change for buy-sell planning?

In Connelly v. United States (2024), the Supreme Court held unanimously that life insurance proceeds held by a corporation to fund a stock redemption must be included in the company's fair market value for estate tax purposes — the proceeds are a corporate asset, not an offset to the redemption liability. For clients with potentially taxable estates, this increases the estate's FMV and the resulting estate tax at exactly the moment the buyout provides liquidity. Cross-purchase structures, where policies are owned by individual co-owners rather than the corporation, avoid the Connelly problem entirely.

Does a buy-sell agreement affect QSBS eligibility?

Yes. IRC §1202(c)(1)(B) requires QSBS to be acquired at original issuance directly from the corporation. In a cross-purchase structure, the purchasing co-owner acquires shares from the selling shareholder — not from the corporation — so the acquired shares are generally not qualifying QSBS. Corporate redemptions under a buy-sell agreement may also interact with the §1202(c)(3) repurchase restriction, which can disqualify shares if the corporation repurchases more than 5% of its stock within the two-year window surrounding a shareholder's acquisition date. Coordinate buy-sell mechanics with QSBS preservation before the agreement is executed. See QSBS Guide 2025 for the full original-issuance and repurchase restriction requirements.

Can a buy-sell agreement price bind the IRS for estate tax purposes?

Yes — under IRC §2703 — if the agreement meets three requirements: it must be a bona fide business arrangement (not a device to pass wealth to heirs at a discount), it must not be designed to transfer property for less than adequate consideration, and its terms must be comparable to those in arm's-length agreements among unrelated parties. Family-owned business buy-sell agreements that set prices among family members require careful analysis against the §2703 test. Agreements that fail the test are disregarded for estate tax — the estate is taxed on fair market value while receiving the contracted price.

When does a buy-sell agreement require disability insurance in addition to life insurance?

Always. Disability is statistically more likely than premature death during active working years, and a disabled co-owner who can no longer contribute creates exactly the ownership disruption a buy-sell is designed to prevent. A disability buyout policy provides funds to purchase the disabled owner's interest after the elimination period (typically 12–24 months). Without disability funding, the surviving active owners operate the business indefinitely with a non-contributing silent co-owner on title — or must fund the buyout from operations or installment arrangements at a time when the business may be absorbing the loss of the disabled owner's contribution.

How often should a buy-sell agreement be reviewed?

At a minimum annually — and immediately whenever business value changes materially, ownership changes, or tax law updates create new planning considerations. Every review should involve both the CPA (tax and basis implications) and the insurance broker (coverage adequacy and policy performance). An agreement last reviewed three or more years ago is almost certainly misaligned with current business value and may reflect a pre-Connelly structure that warrants reconsideration.

Arvori connects CPAs and insurance brokers in a shared client platform — so buy-sell reviews, coverage gaps, and tax planning surface in the same workflow rather than in separate conversations that never meet. Learn more at arvori.app.