Life Insurance Buy Sell Agreement

What a Buy-Sell Agreement Actually Does When Someone Dies

A buy-sell agreement is a legally binding contract between business co-owners that determines what happens to a departing owner's share. When one owner dies, the agreement may require a transaction: the surviving owners (or the company itself) purchase the deceased owner's interest at a price set by the agreement's valuation formula.

Without one, the deceased owner's estate inherits their business interest. That means the surviving spouse or children become your new business partner — whether they know anything about the business or not. Surviving partners lose control over who they work with. The family gets an illiquid asset they can't easily sell.

Life insurance is what makes the agreement actually executable. The death benefit provides immediate cash to fund the buyout, so surviving owners don't need to drain company reserves, take on debt, or sell assets at fire-sale prices.

Cross-Purchase vs. Entity Redemption: Two Structures, Very Different Tax Outcomes

There are two ways to structure an insurance-funded buy-sell agreement, and the choice has massive tax consequences — especially after the Supreme Court's 2024 Connelly v. United States ruling.

Cross-purchase agreements work like this: each owner buys and pays for a life insurance policy on every other owner. When an owner dies, the surviving owners personally receive the death benefit (tax-free) and use it to buy the deceased's shares directly from the estate.

The tax advantage is significant. The surviving owners get a stepped-up cost basis equal to the purchase price they paid. When they eventually sell the business, they only pay capital gains on the appreciation above what they paid for the deceased's shares.

Entity redemption (stock redemption) agreements work differently. The company itself owns and pays for a policy on each owner's life. When an owner dies, the company receives the death benefit and uses it to buy back (redeem) the deceased's shares.

The problem: surviving owners get no basis step-up. Their original cost basis stays the same, which means a much larger capital gains bill down the road.

The Connelly Ruling Changed Everything for Redemption Agreements

In Connelly v. United States (2024), two brothers owned a corporation with a redemption buy-sell agreement funded by a $3.5 million company-owned life insurance policy on each brother. When one brother died, the company collected the $3 million death benefit and used it to redeem the deceased brother's 77.18% share.

The estate argued the company was worth $3.86 million and that the redemption obligation offset the insurance proceeds. The Supreme Court unanimously disagreed. The Court ruled that the life insurance proceeds are a corporate asset that increases the company's fair market value — and the obligation to redeem shares is not a deductible liability.

The result: the company's value jumped to $6.86 million for estate tax purposes, increasing the deceased brother's taxable share from $3 million to $5.3 million. The family owed an additional $889,914 in federal estate taxes.

For any business owner with an entity redemption agreement, this ruling is a wake-up call. The very insurance meant to fund a smooth buyout can inflate the estate tax bill.

Which Structure Should You Choose?

For businesses with two or three owners, a cross-purchase agreement may offer tax advantages: death benefits stay out of the company's balance sheet, surviving owners get a purchase-price basis, and Connelly does not apply in the same way.

The practical problem with cross-purchase agreements is scale. With two owners, you need two policies. With three, you need six. With five owners, you need twenty. Each owner must pay premiums on every other owner's policy, and managing that web of policies gets expensive and complex.

Entity redemption is simpler to administer — the company owns one policy per owner and pays the premiums. But after Connelly, the estate tax exposure can be severe.

A hybrid approach — often called a "wait-and-see" buy-sell — gives surviving owners the first option to buy shares personally (cross-purchase), with the entity stepping in to purchase any remaining shares. This captures the basis step-up on the cross-purchased portion while keeping the administrative simplicity of entity ownership for the remainder.

What Happens If There's No Buy-Sell Agreement at All

If no buy-sell agreement exists, default state law controls what happens to the deceased owner's business interest:

• LLC members become "dissociated." The estate inherits economic rights (profits and distributions) but typically no voting or management authority — leaving the family with income they can't control.
• Partnership interests may trigger automatic dissolution unless the partnership agreement says otherwise.
• Corporate shares pass through the estate like any other asset, but the deceased may have been the only authorized signer on bank accounts, creating an operational freeze.

In every case, the surviving owners and the family are stuck negotiating a buyout price without a pre-agreed formula, while the business bleeds value.

Steps to Take Right Now

If a business owner in your family has just died and a buy-sell agreement exists, locate the agreement and the insurance policy immediately. Confirm who owns the policy, who the beneficiary is, and whether the death benefit matches the current valuation formula. Submit the insurance claim promptly; processing time depends on the policy and carrier.

If you're a surviving business owner and you don't have a buy-sell agreement yet, talk to a business attorney before another month passes. The cost of setting one up is a fraction of the chaos that unfolds without one.

For families navigating this process right now, the Small Business Owner Dies — What the Family Needs to Do toolkit walks through the full sequence — from the first 48 hours through buy-sell execution, estate tax filing, and entity dissolution — with worksheets to track every moving part.