Businesses with more than one owner benefit from having multiple viewpoints and varying skill sets. However, they also face serious risks of uncertainty and conflict if one of the owners suddenly departs or undergoes a major life change. A carefully crafted buy-sell agreement can guard against these risks — if it’s securely funded.
Transfer guidelines
A “buy-sell” (as it’s often called) is a legally enforceable contract among a company’s owners that sets guidelines for transferring ownership interests. It gives the remaining owners or the business itself the right — or, in some cases, the responsibility — to buy an exiting owner’s interest if a “triggering event” occurs. Such events may include an owner’s death, disability, divorce, retirement, voluntary departure, and loss of professional license or certification.
Essentially, the buy-sell creates a market for a withdrawing owner’s interest. It also defines how the price of an ownership interest will be determined, including identifying a valuation method and standard of value. By outlining when and to whom interests can be sold — and for how much — the agreement ultimately helps prevent conflicts among remaining owners or with the withdrawing owner’s family.
Popular choice
When a triggering event occurs, a substantial amount of money is typically needed to buy the departing owner’s interests. So, it’s critical to properly fund a buy-sell.
One popular choice is life insurance. Although such coverage might seem useful only to provide liquidity in the event of an owner’s death, it’s not limited to such situations.
The right policy, sometimes combined with riders or other types of coverage, can help ensure that departing owners or their beneficiaries efficiently receive the agreed-upon price for ownership interests following eligible triggering events. Meanwhile, it can ease the strain on the company’s cash flow and reduce the likelihood that the business will have to sell assets to fund an ownership.
Various structures
Buy-sells can be structured to use life insurance in various ways. One option is a cross-purchase agreement, where each owner takes out a policy on each of the other owners.
For example, let’s say you buy coverage for your business partner. If that individual dies, triggering the buy-sell, you’ll collect the death benefit and use it to buy the ownership interest from your partner’s estate.
Assuming it’s large enough, the policy should guarantee you’ll have the funding to fulfill your obligations under the agreement. Other benefits include:
On the downside, a cross-purchase agreement can be cumbersome if there are more than a few owners because of the number of policies required. It can also be unfair if there’s a significant disparity in owners’ ages or health, causing the policy premiums to vary substantially.
One alternative is establishing a trust or separate partnership to buy a policy on each owner. If an owner dies, the trust or partnership collects the death benefits on behalf of the remaining owners and pays each one’s share of the ownership interest buyout.
Another option is a redemption agreement. Under this approach, the business — not the individual owners — buys a policy on each owner’s life. The company holds the insurance and receives the proceeds following a qualifying triggering event, which it then uses to buy a departing owner’s interest.
A disadvantage of a redemption agreement is that the remaining owners won’t receive a step-up in basis when the company buys the departing owner’s interest. This can result in higher capital gains taxes.
Additionally, in the 2024 case of Connelly v. United States, the U.S. Supreme Court held that the value of corporate-owned life insurance used to meet a redemption agreement should be included in the value of a deceased owner’s business interest for federal estate tax purposes. And that doesn’t include any offsetting reduction for the company’s obligation to redeem the deceased owner’s interest.
The ruling may have adverse consequences for estates subject to the federal estate tax. Under current law, the unified federal estate and gift tax exemption is $13.99 million for 2025 and $15 million for 2026.
We can help
The bottom line is, if not properly funded, a buy-sell agreement won’t likely benefit anyone. Work with your attorney to create and occasionally review yours. Meanwhile, we can help you choose an optimal funding strategy and advise you on the tax implications.
