Using Life Insurance to Fund a Buy-Sell Agreement

Start with the agreement's obligation

A buy-sell agreement addresses what happens to an ownership interest after specified events. Death may be one trigger; disability, retirement, resignation, divorce, or another event can be addressed differently. Ordinary life insurance supplies a death benefit under its terms and does not automatically fund every trigger in the agreement.

Before selecting coverage, identify who must buy, who must sell, how the price is calculated, when payment is due, and what happens if insurance is insufficient or unavailable. An agreement may permit installment payments or another funding method, but that is a legal provision to review rather than an assumption to add to a sales illustration.

Check whether the current document is signed, whether all owners are parties, and whether later amendments exist. A sample agreement or an old unsigned draft is not a reliable basis for a funding decision. The policy owner and beneficiary should be compared with the final executed structure.

If the agreement is only one part of a family-business transition, also review the business succession guide. The purchase obligation, management handoff, and treatment of other heirs can require different resources even when they arise from the same death.

Compare cross-purchase and entity-purchase money flows

These are broad descriptions, not instructions to implement one structure. Entity type and the parties' tax circumstances matter. More owners can make a straightforward cross-purchase structure administratively complex, while simpler policy ownership under an entity arrangement does not eliminate legal or tax questions.

Do not select the structure only by counting policies. Determine who should own the business after the transaction and which buyer can carry out the obligation. The insurance is then evaluated as a funding source for that arrangement.

Understand why Connelly belongs in the review

In its June 2024 Connelly v. United States decision, the Supreme Court addressed corporate-owned life insurance used to redeem a deceased shareholder's interest. It held that the fair-market-value redemption obligation did not offset the proceeds in the corporate valuation at issue. Official Supreme Court opinion.

The practical question is whether insurance proceeds change the business value used in the estate and purchase analysis. Do not assume money earmarked for a redemption disappears from value simply because an agreement says it will be spent. The opinion does not mean every buy-sell arrangement should be abandoned or that a cross-purchase structure is always superior.

Have counsel and the valuation professional review an existing entity-owned arrangement in light of the decision. Changing policy ownership or the agreement can create additional consequences, so the response should be a coordinated analysis rather than an immediate transfer based on an article.

Keep business valuation separate from the insurance amount

The value stated when a policy was purchased can become stale. Earnings, debt, ownership percentages, intellectual property, and market conditions can change. A policy amount that once matched the expected buyout may now be too small or unnecessarily large.

Ask how the agreement establishes value: a formula, periodic agreed figure, appraisal process, or another method. Then check whether the required updates were actually completed. A provision calling for annual certification offers limited clarity if the last certification occurred years ago.

The price under the agreement and a value accepted for tax purposes are not automatically the same. Ask the legal and valuation advisers whether the method and restrictions meet the relevant requirements. An insurer's willingness to issue a face amount is not an appraisal and does not validate a purchase price.

Keep a record showing the valuation date, ownership percentage, resulting purchase obligation, policy proceeds expected for that buyer, and the remaining funding gap. Revisit it after an acquisition, debt change, or new partner joins.

Work through a transparent funding example

Suppose, purely hypothetically, an agreement calls for a $900,000 purchase at an owner's death. The intended buyer has $600,000 of applicable life insurance and $100,000 of cash genuinely reserved for the purchase. The apparent gap is $200,000 before considering taxes, expenses, assignments, or changes in value.

The group should then ask whether the agreement permits a note, whether the buyer can make the payments, and what security the seller's estate receives. It should also ask whether taking $100,000 of business cash would compromise payroll or debt covenants. A reserve is not available twice simply because two documents mention it.

If the policy is assigned to a lender, the amount available for the purchase may be lower than the face amount. If proceeds affect entity valuation, the purchase obligation may require recalculation. This example demonstrates why matching one static death-benefit number to one old valuation is insufficient.

The seller's estate also needs to understand when purchase payments arrive. The estate liquidity guide distinguishes an eventual asset value from cash available when an obligation is due.

Budget for unequal underwriting and unfunded triggers

Owners can differ in age, health, and insurability. One person's coverage may cost substantially more or be unavailable on the hoped-for terms. The agreement should address those possibilities through counsel rather than assuming all owners will receive equivalent offers.

Compare premium allocation openly. In a cross-purchase arrangement, the person paying a premium may be insuring someone else. In an entity arrangement, the business bears costs that may affect owners differently. Appropriate accounting and legal treatment should follow the actual structure.

Death funding does not resolve a retirement purchase or a disability-triggered buyout while the insured is alive. Those events need separate cash, financing, insurance where suitable, or agreement provisions. Avoid describing a life policy as complete buy-sell funding when it addresses only one event.

Review tax rules before issuance or transfer

Certain employer-owned policies require a section 101(j) analysis, including pre-issuance notice and consent, applicable exceptions, and reporting. This can matter where the entity owns a policy on an owner who is also an employee. IRS employer-owned contract guidance.

The IRS also describes the general transfer-for-value limitation on the income exclusion for life proceeds and its exceptions. A policy transferred among owners or into a different structure deserves review before the transfer occurs. IRS life insurance proceeds guidance.

Do not assume premiums are deductible because the coverage funds a business obligation. IRS business-expense guidance discusses restrictions when the business is a beneficiary. IRS Publication 334. Ask advisers to model the transaction's full effect, including the purchase and ownership consequences, rather than quoting only the death benefit's general income-tax treatment.

Choose policy duration around the agreement

Term insurance may suit an obligation expected to end or change at a planned sale or retirement. Permanent insurance can be considered for a longer need when funding is sustainable. An expected retirement date is not a guarantee the business can complete a purchase at that time.

Compare the period during which premiums are level, the coverage termination age or date, conversion options, and any guarantees. For permanent coverage, request less favorable illustrations as well as current assumptions. Policy loans or withdrawals can reduce the very proceeds intended to fund the agreement.

If existing policies are reviewed, do not cancel them until any proposed replacement has been fully evaluated and its effective status confirmed. A new contestability period, changed underwriting, surrender cost, or tax consequence can affect the comparison.

Give the arrangement an operating checklist

Assign responsibility for premium payment, annual policy verification, valuation updates, and recordkeeping. Keep the executed agreement, policy owner and beneficiary confirmations, assignments, consent records, and adviser contacts together in a secure location.

At least review the arrangement when an owner joins or leaves, ownership percentages change, a marriage or divorce affects obligations, the business is reorganized, or new borrowing is added. Confirm what happens to each policy if an owner departs while living. Transfers and surrenders should follow an agreed process with professional review.

At a death, the buyer, executor, insurer, and advisers must coordinate the claim and purchase. Do not promise that proceeds are immediately available or that the purchase can close without required documents. Maintain operational liquidity for the interval while those steps occur.