What Is a Buy-Sell Agreement — And Why Does Life Insurance Fund It?

A buy-sell agreement is a legally binding contract between business co-owners that dictates exactly what happens to an owner's share of the business if they die, become disabled, retire, or leave. Think of it as a prenuptial agreement for business partners. Without one, a deceased owner's heirs could end up with a stake in your company — creating conflict, financial strain, or even a forced liquidation.

Life insurance is the most common and cost-effective way to fund a buy-sell agreement. When a triggering event occurs (most often an owner's death), the life insurance policy pays out a death benefit that gives the surviving partners or the business the immediate cash needed to buy out the departing owner's interest — without tapping into business reserves or taking on debt.

Here's what makes a life insurance-funded buy-sell agreement so powerful for partnerships, LLCs, and S-corps:

• Guaranteed funding — The buyout money is available the moment it's needed
• Income tax-free proceeds — Surviving owners or the business receive death benefits free of income tax
• Business continuity — Operations continue without disruption or forced asset sales
• Fair compensation to heirs — The deceased owner's family receives full agreed-upon value for their interest

Cross-Purchase vs. Entity Purchase: The Two Main Structures

Choosing the right structure is one of the most important decisions when setting up a buy-sell agreement life insurance plan. There are two primary types, each with distinct ownership rules, tax consequences, and scalability considerations.

Cross-Purchase Buy-Sell Agreement

In a cross-purchase agreement, each owner individually purchases a life insurance policy on every other co-owner. When one owner dies, the surviving owners use the death benefit proceeds to buy the deceased's business interest directly from the estate.

Example: If Partners A and B co-own a business, Partner A buys a policy on Partner B and vice versa. When Partner B passes away, Partner A collects the death benefit and uses it to purchase Partner B's share.

Key advantage: Surviving owners receive a stepped-up cost basis in the shares they acquire, which means lower capital gains taxes if they eventually sell the business.

Key drawback: The number of required policies grows rapidly. With 5 owners, you'd need 20 separate policies. This makes cross-purchase agreements best suited for businesses with 2 to 3 owners.

Entity Purchase (Stock Redemption) Buy-Sell Agreement

In an entity purchase agreement, the business itself owns life insurance policies on each owner. When an owner dies, the company collects the death benefit and uses it to redeem or buy back the deceased's ownership interest from their estate.

Key advantage: Far simpler administration — only one policy per owner is needed, regardless of how many partners exist.

Key drawback: Surviving owners do not receive a stepped-up basis, which can result in higher capital gains taxes down the road. Additionally, following the landmark Connelly v. United States Supreme Court ruling in 2024, life insurance proceeds received by the company in an entity purchase plan can increase the company's fair market value, potentially inflating the deceased owner's taxable estate.

Which Structure Is Right for You?

For businesses anticipating ownership changes or growth, a hybrid (wait-and-see) approach can also work, allowing owners to decide after a triggering event whether the business or the surviving owners will complete the purchase. Understanding similar concepts like key man insurance can also help you cover all your business risk bases.

Tax Implications of Buy-Sell Agreement Life Insurance

Taxes are one of the most nuanced — and most important — parts of a buy-sell agreement funded with life insurance. Here's what every business owner needs to understand heading into 2026.

Premiums Are Not Tax-Deductible

Whether it's a cross-purchase or entity purchase plan, life insurance premiums used to fund a buy-sell agreement are not tax-deductible. The IRS treats these as personal expenses, not business expenses. You're paying with after-tax dollars regardless of the structure.

Death Benefits Are Generally Income Tax-Free

The upside: death benefit proceeds received by individuals or the business are excluded from income tax under IRC Section 101(a). This is one of the key reasons life insurance is the preferred funding method for buy-sell agreements.

However, watch for the transfer-for-value rule — if a life insurance policy is sold or transferred for consideration, the death benefit can become partially taxable. Transfers between business partners or to the insured corporation generally qualify for exceptions, but consult a tax professional before any policy transfer.

Estate Tax Considerations (Post-Connelly Ruling)

The 2024 Connelly v. United States Supreme Court decision changed the landscape for entity purchase agreements. The Court ruled that life insurance proceeds received by the company upon an owner's death must be included when calculating the company's fair market value — which flows directly into the deceased owner's taxable estate.

This means survivors in an entity plan could face a significantly larger estate tax bill than expected — without any offsetting redemption obligation reducing the company's value. This is why many advisors are now steering business owners back toward cross-purchase structures or trusteed cross-purchase arrangements, where a neutral trustee holds all policies to simplify administration while preserving the tax benefits. For deeper reading on how life insurance interacts with estate planning, see our guide on estate liquidity planning.

How to Structure a Buy-Sell Agreement — And Common Mistakes to Avoid

Step-by-Step: How to Set One Up

1. Engage an attorney and financial advisor — Buy-sell agreements require legal drafting and insurance expertise working together
2. Agree on a business valuation method — Fixed price, formula-based, or independent appraisal (reviewed annually)
3. Choose your agreement type — Cross-purchase, entity purchase, or hybrid
4. Determine the coverage amount — Each policy should be sized to match each owner's proportional business value
5. Select the right policy type — Term life is most affordable; permanent (whole or universal life) builds cash value and has no expiration
6. Establish proper ownership and beneficiary designations — Mismatched ownership is one of the most common and costly errors
7. Review and update regularly — At minimum, revisit the agreement annually or after major business events

Common Mistakes That Derail Buy-Sell Agreements

The biggest pitfalls business owners fall into include:

• Letting the agreement go stale — A buy-sell agreement written when the business was worth $500K is dangerous when the business is now worth $5M. Update the valuation regularly.
• Misaligned insurance and agreement terms — The policy payout must match the buy-sell price. Gaps in coverage leave surviving partners scrambling for funds.
• Omitting key trigger events — Don't just plan for death. Include disability, divorce, voluntary departure, bankruptcy, and retirement.
• Improper ownership designations — In an entity plan, the company must be both owner and beneficiary. In a cross-purchase plan, each individual owner must own the policy on their partner.
• Ignoring the Connelly ruling — Existing entity purchase agreements may now carry unintended estate tax exposure. Review yours with an attorney immediately.
• Using a generic template — A one-size-fits-all document won't account for your state's laws, your business structure, or your partners' unique situations.

Business owners should also explore complementary tools like split dollar life insurance as part of a broader executive and business planning strategy. And since estate taxes are a growing concern for closely held businesses, pairing your buy-sell plan with a solid estate liquidity strategy can provide even stronger protection.

Frequently Asked Questions

What is a buy-sell agreement in life insurance?

A buy-sell agreement in life insurance is a legally binding contract between business co-owners that uses life insurance policies to fund the purchase of a departing or deceased owner's business interest. When a triggering event like death occurs, the life insurance death benefit provides immediate cash to execute the buyout. This protects the business from disruption while ensuring the departing owner's family receives fair compensation. It's one of the most essential succession planning tools for partnerships, LLCs, and S-corps.

Is life insurance the best way to fund a buy-sell agreement?

Life insurance is widely considered the most efficient funding method because it provides guaranteed, income tax-free cash exactly when it's needed most — at the time of an owner's death. Alternative methods like installment payments, business loans, or sinking funds all carry risks: they rely on the business having sufficient cash flow or credit at the time of the triggering event. Life insurance eliminates that uncertainty with a guaranteed death benefit that's typically received free of income tax.

Are buy-sell agreement life insurance premiums tax-deductible?

No — premiums paid for life insurance policies used to fund a buy-sell agreement are not tax-deductible, whether paid by the business (entity purchase) or individual owners (cross-purchase). The IRS treats these as non-deductible personal or business expenses since the policyholder is also the beneficiary. However, death benefit proceeds are generally received income tax-free, which is a significant financial advantage.

What did the Connelly Supreme Court ruling mean for buy-sell agreements?

The 2024 Connelly v. United States ruling by the U.S. Supreme Court established that in an entity purchase buy-sell agreement, life insurance proceeds received by the company upon an owner's death must be counted when determining the company's fair market value for estate tax purposes. This can significantly increase the deceased owner's taxable estate, resulting in unexpected estate tax bills for heirs. Business owners with entity purchase agreements should have an attorney review their structure to assess their exposure and consider whether a switch to a cross-purchase plan makes sense.

Who needs a buy-sell agreement funded with life insurance?

Any business with two or more co-owners should have a buy-sell agreement in place, including general partnerships, limited partnerships, LLCs, S-corporations, and closely held C-corporations. If a co-owner died tomorrow with no buy-sell agreement in place, the business could face a legal dispute with the deceased's heirs, a forced sale, or serious financial instability. Life insurance-funded buy-sell agreements are particularly critical for businesses where the owners play an active role in day-to-day operations, as their loss would have an immediate operational and financial impact.