A buy-sell agreement is a legal contract that determines what happens to a business owner's interest when they die, become disabled, or leave the company. Life insurance is the most common and generally the most dependable way to fund that agreement, because it creates an immediate pool of cash. Without insurance funding, the agreement is just a promise; the surviving owners may not have the cash to honor it.
Is this a fit for you?
Who This Is For
- You have a buy-sell agreement that is currently unfunded or underfunded
- Your business has two or more owners and no clear plan for what happens at death
- You want to guarantee that your family receives fair value for your ownership stake
- Your buy-sell uses entity-redemption and has not been reviewed since Connelly (June 2024)
- You need to update your business valuation and match insurance coverage to the new number
Who This Is Not For
- You are a sole proprietor with no co-owners and no succession plan
- All owners have sufficient personal liquidity to fund a buyout without insurance
- You plan to liquidate the business rather than transfer ownership
- The business has no tangible value beyond the current owners' personal effort
How do the options compare?
| Method | How It Works | Pros | Cons |
|---|---|---|---|
| Life insurance | Policies fund the buyout at death | Immediate cash, guaranteed amount, cost-effective | Requires ongoing premium payments |
| Company cash reserves | Business saves cash for the buyout | No insurance cost | Ties up working capital, may not be enough |
| Installment payments | Surviving owners pay over time | No upfront cost | Burdens the business, family waits years |
| Sinking fund | Set aside money annually | Disciplined savings | Takes years to accumulate, may fall short |
| Bank loan | Borrow to fund the buyout | Immediate funding | Interest cost, debt burden, approval risk |
What are the risks, costs, and alternatives?
Connelly v. United States (2024)
The Supreme Court ruled that company-owned life insurance proceeds used for entity redemption increase the company's fair market value for estate tax purposes. If your buy-sell uses entity redemption, the deceased owner's estate may owe significantly more taxes than planned. Review your structure immediately.
Stale valuations
A buy-sell price set years ago may undervalue or overvalue the business today. The family of a deceased owner could challenge a below-market price, or surviving owners could overpay. Use annual valuations or a formula tied to current revenue and earnings.
Mismatched coverage
If the business is worth $10 million per owner and the insurance is only $6 million, there is a $4 million gap. Review coverage annually against updated valuations.
Policy ownership errors
In a cross-purchase arrangement, each owner must own the policy on the other owner. If the business accidentally owns the policies, you have an entity-redemption arrangement with Connelly exposure.
Disability is the more common gap
For working-age owners, long-term disability is statistically more likely than premature death, yet most buy-sells fund only the death trigger. Pair the life insurance with a disability buy-out (DBO) policy, such as the dedicated DBO contracts offered by several highly rated carriers, so the same agreement can be executed if an owner is permanently disabled rather than deceased. DBO policies typically pay a lump sum or scheduled installments after a 12 to 24 month elimination period.
What does this look like in practice?
Pinnacle Construction: Closing the Funding Gap
Illustrative example: not an actual client.
Pinnacle Construction is owned 60/40 by two partners. Their buy-sell agreement was signed eight years ago with a $4 million valuation. The company is now worth $11 million. The existing $2 million in life insurance per partner covers less than half the current buyout price.
Living Prepared conducted a coverage gap analysis and recommended increasing coverage to $6.6 million on the majority partner and $4.4 million on the minority partner, matching their ownership percentages. The structure was changed from entity redemption to cross-purchase to eliminate Connelly exposure.
Total additional premium cost: $8,200 per year. The alternative was a $4.6 million funding gap that would have forced installment payments over seven years, straining the company during its most vulnerable period.
Illustrative scenario for educational purposes. Coverage amounts and premiums vary.
Common Questions
Why fund a buy-sell agreement with life insurance instead of cash reserves?
Life insurance is designed to create an immediate pool of cash exactly when a buyout is triggered, subject to the claims-paying ability of the issuing insurance company. Cash reserves tie up working capital and may not be enough, installment payments burden the business for years, and a sinking fund can take years to accumulate.
What is the difference between a cross-purchase and an entity-redemption buy-sell?
In a cross-purchase, each owner personally owns a policy on the other owners and buys the departing owner's share. In an entity redemption, the business owns the policies and buys the interest. The distinction matters for taxes and, since Connelly, for how insurance proceeds affect the company's estate-tax value.
How does the Connelly decision affect an entity-redemption buy-sell?
In Connelly v. United States (2024), the Supreme Court held that company-owned life insurance proceeds used for entity redemption increase the company's fair market value for estate tax purposes. A deceased owner's estate may then owe more than planned. Owners using entity redemption should review the structure, since a cross-purchase can reduce that exposure.
Should a buy-sell agreement cover disability as well as death?
Most buy-sells fund only the death trigger, yet a working-age owner can become permanently disabled and unable to continue. Pairing life insurance with a disability buy-out policy lets the same agreement be executed if an owner is disabled rather than deceased. These policies typically pay after a 12 to 24 month elimination period.
Related Questions
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