A buy-sell agreement life insurance policy is one of the most reliable ways to protect a closely held business when a partner exits unexpectedly. Whether a co-owner retires, becomes disabled, or passes away, the right funding method ensures the remaining partners can purchase the departing owner’s shares without draining operating capital or taking on debt. Choosing between a cross-purchase agreement and an entity purchase agreement depends on the number of partners, tax considerations, and how the business is structured.
Every co-owned business faces a straightforward risk: if one partner suddenly leaves, who pays for their ownership stake, and where does the money come from? A buy-sell agreement answers both questions in advance, but the agreement itself is only as strong as the funding behind it. Without a reliable source of capital, even a well-drafted contract can leave surviving partners scrambling.
Why buy-sell agreement funding matters for business continuity
A buy-sell agreement is a legally binding contract that spells out what happens to a partner’s ownership interest when a triggering event occurs. Common triggers include death, disability, retirement, divorce, or bankruptcy. The agreement defines how the departing partner’s shares are valued and who has the right, or obligation, to purchase them.
The funding mechanism is what makes the agreement enforceable. Without it, the remaining owners may need to liquidate assets, borrow money at unfavorable terms, or sell the business entirely. Buy-sell agreement life insurance eliminates that uncertainty by providing a lump-sum payout precisely when it is needed most.
Disability is equally important to plan for. A disability buyout insurance policy covers the scenario where a partner can no longer work but is still alive. Because disability is statistically more likely than death during working years, many business advisors recommend pairing life insurance with disability buyout coverage for complete protection.
Cross-purchase agreement: how it works and when to use it
A cross-purchase agreement requires each partner to buy and maintain an insurance policy on every other partner. When a partner dies or becomes disabled, the surviving partners use the insurance proceeds to buy the departing partner’s ownership shares directly.
This structure offers a significant tax advantage. Because the surviving partners purchase shares with their own funds (the insurance proceeds), they receive a stepped-up cost basis in the acquired shares. That higher basis can reduce capital gains taxes substantially if the business is later sold, an outcome worth modeling with a tax advisory professional before the agreement is signed.
This type of arrangement works best when there are two or three partners. The reason is simple math: each partner must hold a separate policy on every other partner. With two partners, that means two total policies. With three, it jumps to six. With five partners, the group would need twenty separate policies, an administrative burden that quickly becomes impractical.
Example: In a two-partner business valued at $2 million with equal ownership, each partner would hold a $1 million life insurance policy on the other. If Partner A dies, Partner B collects $1 million in proceeds and uses it to purchase Partner A’s shares from their estate. Partner B now owns 100% of the business with a cost basis that reflects the full purchase price.
Entity purchase agreement: a simpler option for larger partnerships
An entity purchase agreement, sometimes called a stock redemption agreement, takes a different approach. Instead of each partner insuring the others, the business entity itself purchases and maintains the insurance policies on each partner’s life.
When a triggering event occurs, the company uses the insurance proceeds to buy back the departing partner’s shares. Those shares are then either retired or redistributed among the remaining owners. This structure is far simpler to manage because the number of policies always equals the number of partners, regardless of how large the group grows.
The trade-off is tax treatment. Because the entity, not the individual partners, purchases the shares, the surviving partners do not receive a step-up in cost basis. If the business is sold later, the partners may face higher capital gains taxes than they would under a cross-purchase arrangement.
Stock redemption arrangements are generally the better choice when a business has four or more partners. They are also common in corporations, where the company’s redemption of stock can be a more straightforward legal transaction than individual buyouts among shareholders. The tax consequences of a corporate redemption depend on whether it qualifies as a sale or a dividend under Internal Revenue Code Section 302, so the agreement should be drafted with that distinction in mind.
How the Connelly decision changed entity purchase planning
A 2024 Supreme Court decision reshaped how owners should think about redemption-funded buy-sell agreements. In Connelly v. United States, decided on June 6, 2024, the Court ruled unanimously that life insurance proceeds a corporation receives to redeem a deceased shareholder’s stock count as a corporate asset that increases the company’s fair market value for estate tax purposes. Importantly, the company’s obligation to redeem those shares does not offset that value.
The practical result can be a larger estate tax bill than owners expect. In the case itself, the corporation held insurance on each of two brothers, and the inclusion of the proceeds raised the value of the deceased owner’s stake well above what the estate had reported, generating substantial additional estate tax. You can read the official opinion through the U.S. Supreme Court Connelly decision.
This ruling matters most for closely held businesses whose total value may approach the federal estate tax exemption. A cross-purchase structure generally avoids the problem because the insurance proceeds flow to the individual owners rather than into the company, so they do not inflate the entity’s value. Some businesses respond by moving to a cross-purchase or hybrid design, or by holding the policies in a separate insurance LLC or trust. Because the right fix depends on each company’s value, ownership, and goals, this is a planning point to review with a CPA and an attorney rather than a reason to abandon redemption agreements outright.
How to choose between cross-purchase and entity purchase
Selecting the right buy-sell agreement funding method comes down to a few key factors:
Number of partners. With three or fewer partners, a cross-purchase structure is usually preferable because the policy count stays manageable and the tax benefits are significant. With four or more partners, an entity-level redemption avoids excessive administrative complexity.
Tax priorities. If minimizing future capital gains taxes is a top priority, the stepped-up basis from a cross-purchase arrangement is a meaningful advantage. If simplicity and ease of administration matter more, an entity purchase approach is the better fit.
Age and health differences among partners. Insurance premiums vary based on each insured person’s age and health. Under an individual cross-purchase structure, younger or healthier partners may pay significantly less for their policies, while older partners face higher costs. A company-funded redemption spreads those costs through the business, which some partnerships find more equitable.
Business structure. C corporations often favor redemption-based agreements because of how corporate buybacks are taxed. S corporations and partnerships may benefit more from individual purchase structures, though the specifics depend on each company’s circumstances. For partnerships, the IRS guidance on partnership taxation outlines how a partner’s interest and basis are treated when an interest changes hands.
Estate tax exposure. After the Connelly decision, corporate-owned insurance funding a redemption can increase the company’s value for estate tax purposes. Owners of higher-value businesses should weigh that exposure when deciding between a redemption and a cross-purchase structure.
Some businesses use a hybrid approach called a “wait-and-see” buy-sell agreement. This structure gives the entity the first right to purchase the departing partner’s shares. If the entity declines or cannot complete the purchase, the remaining partners then have the right to buy the shares individually through a cross-purchase. Hybrid agreements offer flexibility but require careful drafting.
The role of business valuation in buy-sell agreements
A buy-sell agreement is only effective if the purchase price reflects the company’s actual value. Setting the price too low shortchanges the departing partner or their estate. Setting it too high forces the remaining partners to overpay, potentially straining the business.
Most advisors recommend hiring a professional business appraiser to establish the company’s fair market value when the buy-sell agreement is first drafted. The valuation should then be updated periodically, at least every two to three years, or whenever a significant change affects the business. New product lines, major contracts, economic shifts, or changes in industry conditions can all move the needle on what the company is worth.
The buy-sell agreement itself should specify which valuation method will be used. Common methods include a fixed-price approach (where partners agree on a value and update it periodically), a formula-based approach (using a multiple of earnings or revenue), or a full independent appraisal at the time of the triggering event. The appraisal method is the most accurate but also the most time-consuming and expensive.
Partners should review the entire buy-sell agreement, not just the valuation, on a regular schedule. Changes in personal circumstances, tax law, or the business itself can make an outdated agreement more harmful than no agreement at all.
Steps to create or review your buy-sell agreement
Building a solid buy-sell agreement involves several coordinated decisions:
1. Identify the triggering events your agreement will cover: death, disability, retirement, voluntary departure, divorce, or bankruptcy.
2. Choose a funding method, cross-purchase, entity redemption, or a hybrid structure, based on your partner count, tax situation, and business type.
3. Obtain a professional business valuation and select an ongoing valuation methodology for the agreement.
4. Purchase the appropriate insurance policies, buy-sell agreement life insurance, disability buyout insurance, or both, with coverage amounts that match the current valuation.
5. Review and update the agreement, the valuation, and the insurance coverage at least every two to three years.
Working with a CPA and an attorney experienced in business succession planning ensures the agreement, the funding, and the tax treatment all align properly. Because a buyout is ultimately a change-of-ownership event, coordinating early with a transaction advisory team helps the structure hold up if the company is later bought or recapitalized.
Frequently Asked Questions
What is buy-sell agreement life insurance?
Buy-sell agreement life insurance is a policy purchased specifically to fund the buyout of a business partner’s ownership shares upon their death. The insurance proceeds provide immediate capital so surviving partners can purchase the departing partner’s interest without borrowing money or liquidating business assets.
What is the difference between a cross-purchase agreement and an entity purchase agreement?
A cross-purchase agreement requires each partner to buy insurance on every other partner, and partners purchase shares directly from a departing owner’s estate. An entity purchase agreement has the business itself buy and maintain the policies, with the company purchasing the shares. Cross-purchase offers tax advantages through a stepped-up cost basis; entity purchase is simpler to administer with more partners.
How many life insurance policies do I need for a buy-sell agreement?
The number depends on your funding structure. A cross-purchase agreement requires each partner to hold a policy on every other partner, so three partners need six policies. An entity purchase agreement requires only one policy per partner, regardless of how many partners exist.
Should I include disability buyout insurance in my buy-sell agreement?
Yes. Disability is more likely than death during working years, yet many buy-sell agreements only address death. A disability buyout insurance policy ensures the agreement can be funded if a partner becomes permanently unable to work, protecting both the departing partner’s financial interest and the remaining owners’ ability to continue the business.
How often should a buy-sell agreement be updated?
Review your buy-sell agreement at least every two to three years, or whenever a major change occurs, such as a new partner joining, a partner leaving, significant growth or decline in business value, or changes in tax law. Outdated agreements can create disputes, underinsurance, or unexpected tax consequences.
Do I need a business valuation for a buy-sell agreement?
A professional business valuation is strongly recommended when drafting a buy-sell agreement. It establishes a defensible fair market value that protects all parties. Without a current valuation, partners may disagree on the purchase price during a triggering event, leading to costly disputes or litigation.
