Funding a buy-sell agreement with life insurance requires coordinating the legal agreement with the capital needed to complete the transaction. A buy-sell agreement can establish what happens to an owner's business interest after death, disability, retirement, or another triggering event, but the agreement alone does not create that capital.
For closely held businesses, that creates an important planning question.
Where Will the Money Come From to Purchase an Owner's Interest?
Cash reserves, borrowing, installment payments, and other resources may all play a role. Life insurance is frequently considered when the agreement includes a buyout at an owner's death because it can provide a source of liquidity at the time the purchase obligation arises.
Funding a buy-sell agreement with life insurance, however, requires more than simply purchasing a policy. The ownership structure, business valuation, death benefit, beneficiary arrangement, tax considerations, and terms of the agreement all need to work together.
What Is a Buy-Sell Agreement?
A buy-sell agreement establishes how an owner's business interest may be transferred when a specified event occurs. Depending on the agreement, triggering events may include death, disability, retirement, or another departure from the business.
The agreement can address who will purchase the interest, how the business will be valued, and the terms under which the transaction will occur. Two common structures are a cross-purchase agreement, in which the remaining owners purchase the departing owner's interest, and an entity purchase or stock redemption agreement, in which the business purchases the interest.
The legal agreement establishes the transaction. The funding strategy determines whether sufficient capital will be available to carry it out.
The Buy-Sell Funding Problem
A buy-sell agreement can create a substantial purchase obligation at exactly the time a business and its owners are dealing with the loss of a key shareholder.
Without dedicated funding, the surviving owners or business may need to use existing cash reserves, borrow money, sell assets, or negotiate an installment purchase with the deceased owner's estate. Each approach can affect cash flow, borrowing capacity, and the financial position of the business.
Life insurance provides another potential source of funding. When an insured owner dies, the policy death benefit can provide liquidity that may be used to satisfy some or all of the purchase obligation, depending on the structure of the agreement and the amount of coverage in force.
This does not make life insurance automatically superior to every other funding method. Its value depends on factors such as insurability, premium cost, business valuation, ownership structure, tax treatment, and whether the coverage continues to match the agreement over time.
Why Life Insurance Is Often Used to Fund a Buy-Sell Agreement
Life insurance can be particularly well suited to funding the death-related obligations of a buy-sell agreement because it creates a source of liquidity tied directly to the event that creates the need for capital.
Several characteristics can make it useful in a properly structured arrangement:
Liquidity at Death:
When an insured owner dies and a valid claim is paid, the death benefit can provide the policy beneficiary with capital that may be used to purchase the deceased owner's business interest. This can reduce the need to rely entirely on business cash flow, borrowing, or the sale of assets at an uncertain time.
Funding a Known Obligation:
A buy-sell agreement may create a significant purchase obligation even when the business does not maintain an equivalent amount of liquid capital. Life insurance allows owners to plan in advance for that potential obligation rather than attempting to raise the full purchase price after an owner's death.
Preserving Business Capital:
Using insurance proceeds for a buyout may allow the business or surviving owners to preserve more of their existing capital for payroll, operations, debt service, and other business needs during the ownership transition.
Potentially Favorable Tax Treatment:
Life insurance death benefits are generally received income tax-free under federal law when applicable requirements are satisfied, but the tax treatment depends on how the arrangement is structured. Employer-owned life insurance, for example, is subject to specific requirements under Internal Revenue Code Section 101(j). Business owners should coordinate policy ownership, beneficiary designations, and applicable notice and consent requirements with their legal and tax advisors.
Greater Funding Certainty:
Unlike a future loan or accumulation of cash reserves, life insurance establishes a defined death benefit while the policy remains in force and its contractual requirements are satisfied. That can provide greater certainty about the source of funds available at an owner's death.
How Life Insurance Funding Works in Practice
Consider two partners, David and Sarah, who each own 50% of a medical practice currently valued at $8 million. Their buy-sell agreement provides that if either owner dies, the surviving owner will purchase the deceased owner's interest from the estate.
Under a cross-purchase arrangement, David owns a life insurance policy on Sarah and Sarah owns a policy on David. Based on the current valuation, each policy has a $4 million death benefit.
If David dies while the arrangement is in force, Sarah receives the death benefit from the policy she owns on David. She can then use those proceeds to purchase David's ownership interest from his estate according to the terms of the buy-sell agreement.
The insurance does not determine what David's interest is worth. The valuation provisions in the agreement—and the value of the business at the time the agreement is triggered—determine the purchase obligation. If the practice grows from $8 million to $12 million while the policies remain at $4 million, the insurance may no longer fully fund the buyout.
That is why the business valuation, buy-sell agreement, and life insurance funding should be reviewed together periodically. A well-designed arrangement at inception can become underfunded as the business grows or ownership changes.
Structuring Life Insurance Buy-Sell Agreements
How the life insurance is owned can materially affect how a buy-sell arrangement works. Two of the most common approaches are cross-purchase and entity purchase arrangements.
| Consideration | Cross-Purchase | Entity Purchase |
|---|---|---|
| Policy Ownership | The owners generally purchase life insurance on one another. | The business owns life insurance on the owners. |
| Beneficiary | The surviving owner or owners receive the insurance proceeds. | The business is generally the beneficiary of the policies. |
| Purchase of the Interest | The surviving owner or owners use the available insurance proceeds to purchase the deceased owner's interest according to the buy-sell agreement. | The business receives the death benefit and uses available funds to redeem the deceased owner's interest. |
| Potential Advantages | Can provide a direct source of liquidity to the purchasing owners and may provide favorable income tax basis consequences for the ownership interests acquired. | Can simplify policy administration, particularly when a business has several owners. |
| Planning Considerations | The arrangement can become administratively complex when there are multiple owners because several policies may be required. | Tax, valuation, and estate planning consequences require careful consideration. |
Why the Connelly Decision Matters
The U.S. Supreme Court's 2024 decision in Connelly v. United States highlighted an important consideration for entity-owned life insurance used to fund stock redemptions.
In Connelly, a corporation received life insurance proceeds following the death of a shareholder and used those funds to redeem his shares. For federal estate tax valuation purposes, the Supreme Court concluded that the corporation's obligation to redeem the deceased shareholder's stock was not a liability that reduced the value of the corporation. As a result, the life insurance proceeds were an asset of the corporation that affected the value of the deceased shareholder's interest for federal estate tax purposes.
The decision does not mean that entity purchase arrangements should never be used. It does mean that business owners should not assume that insurance proceeds and a corresponding redemption obligation will simply offset one another for estate tax valuation purposes.
For businesses using—or considering—entity-owned life insurance, the buy-sell agreement, policy ownership, business valuation methodology, and potential estate tax consequences should be reviewed together with legal and tax advisors.
Planning for Disability, Retirement, and Other Ownership Transitions
Life insurance is designed primarily to address the funding need created by an owner's death. A comprehensive buy-sell agreement, however, may also address disability, retirement, voluntary departure, termination, divorce, or other events that could trigger a transfer of ownership.
Those events generally require different funding strategies. For example, disability buyout insurance may provide funds when an owner meets the policy's definition of disability. Retirement or voluntary buyouts may instead be funded through business cash flow, accumulated reserves, installment payments, borrowing, or a combination of approaches.
Permanent life insurance may accumulate cash value that could become one financial resource available to the policy owner during life, but that does not mean the policy should automatically be designed as the primary funding mechanism for a future retirement buyout. Accessing policy values can also affect policy performance and the death benefit.
The important distinction is that the buy-sell agreement should define the triggering events and purchase obligations, while the funding strategy should be designed around the financial characteristics of each event.
Coordinating Buy-Sell Planning With the Advisory Team
Buy-sell planning often requires coordination among the business owner's attorney, CPA, insurance advisor, and other financial professionals. The agreement, business valuation, ownership structure, and funding strategy should be evaluated together rather than as separate planning decisions.
For advisors, the funding analysis can also uncover broader planning issues. Changes in business value, ownership percentages, policy performance, or the owner's estate plan may affect whether an existing arrangement will still accomplish its intended purpose.
Periodic review is especially important when life insurance is part of the funding strategy. Coverage that was appropriate when an agreement was established may become insufficient as the business grows, or the structure itself may need to be reconsidered as tax law, ownership, or succession objectives change.
Is Your Buy-Sell Agreement Properly Funded?
A well-drafted buy-sell agreement establishes how an ownership transition should occur. A well-designed funding strategy helps ensure the capital is available to carry out that plan.
Life insurance can be an effective funding tool when an owner's death creates a purchase obligation, but the appropriate structure depends on the business, its owners, the agreement, valuation, tax considerations, and the amount of coverage required.
Business owners should periodically ask whether the agreement reflects the current value and ownership of the business, whether the insurance remains adequate, and whether the ownership and beneficiary structure still supports the intended transaction.
