Funding a Buy-Sell Agreement


Tax Issue

Buy-sell agreements are part of a succession plan put in place to protect the financial interests of the owners and their heirs and to protect the company’s stability in case of an untimely death of one of the owners. The agreement is a legally binding contract that determines who can buy an interest in the company, how much the deceased owner’s share in the company was worth, and whether or not the estate of the deceased must sell.

However, the agreement itself does not fund the buyout. The surviving business partner(s) must come up with the money to pay the deceased owner’s heirs. The heirs generally want the payout soon after death so that taxes and other final expenses can be paid and the estate can be settled. However, the surviving business owner(s) may not have enough cash to pay the heirs. The surviving owner may not be able to borrow the money either. The business could be sold, but if the operation is good, the surviving owner would likely want to keep the business going. Even if the business is sold, there is no guarantee that a fair price would be received or that it could be sold in a timely manner. The lack of liquidity could put the surviving owner’s stake in the business, as well as the ongoing viability of the business, at risk.

Applicable Tax Law

  • Death benefits from life insurance contracts are not taxable to the beneficiary for income tax purposes.
  • Life insurance policies, at the time of application, require an insurable interest. An insurable interest refers to the determination of the need for insurance. An owner of a policy must have an insurable interest in the person whose life is being insured.
  • Heirs of a deceased business owner receive stepped-up basis on the interest in the business.

Tax Planning Strategies

Cross-purchase life insurance. Business owners can fund buy-sell agreements by purchasing life insurance on the life of the other owner(s). A business owner has an insurable interest in the life of a business partner because of the potential financial loss due to the death of the partner. In purchasing life insurance on the other business owner(s), the purchasing business owner would name himself or herself as the beneficiary. When the other owner dies, the proceeds are paid to the beneficiary income tax free. The beneficiary can then use the money to purchase the share of the business from the deceased owner’s heirs.

The deceased owner’s heirs receive the business interest on a stepped-up basis. Therefore, when the surviving owner buys the interest in the business from the heirs, there is no tax due on the sale of the business. In addition, because the transactions for the life insurance purchase, cash values (if any), and death benefits occur outside of the business, the life insurance proceeds are not subject to claims of the company’s creditors.

The strategy can be employed for businesses that have two or more owners. When more than two owners are involved, each owner must purchase a pro-rated amount of insurance on each other owner.

Type of insurance policy. Business owners can purchase term or permanent life insurance on the other owners. Term life insurance can be a cost effective way to obtain the needed coverage. Permanent insurance, such as universal life insurance, can provide the death benefit coverage needed, while also providing future cash value in the policy. If the business owner whose life in insured does not die, the cash values can be accessed by the owner of the insurance policy. The funds from the cash value, along with other money, can be used to purchase the other parts.

Stock redemption agreement. In a stock redemption agreement, the company buys life insurance on the lives of the owners. When one of the owners dies, the company receives the death benefit proceeds and uses this to purchase the deceased owner’s interest in the company from the heirs. For multiple owners companies, this can reduce the number of life insurance policies that are needed.


Example #1: Julie and Sam each owner a 50% stake in Dogs and Cats, a partnership. They have a buy-sell agreement in place with an agreed upon buyout of $200,000. Julie takes a life insurance policy on Sam’s life in the amount of $200,000, naming herself as beneficiary. Sam takes a life insurance policy on Julie’s life in the amount of $200,000, naming himself as beneficiary.

Sam dies two years later. Julie places a claim for $200,000 for the life insurance death benefit. When she receives the death benefit tax free and uses the proceeds to buy Sam’s interest in the business from Sam’s wife, Sarah, Julie now owns 100% of the business, and Sam’s heir received the agreed-upon value of the business.

Possible Risks

  • The agreements bind the heirs to the agreed-upon transaction. The business interest of the deceased must be sold.
  • Businesses that are owned by more than two people can experience a shift in control of the business after the death of one of the owners. For example, Tim owns 40% of a business, Tom owns 30%, and Bill owns 30%. If bill dies, Tim will be a 55% owner and Tom will be a 45% owner. Issues such as this need to be addressed in drafting the agreement and the funding of the agreement.
  • Businesses that have more than two owners require multiple insurance policies which can be complicated in setting up and maintaining.
  • Valuation changes in the business need to be addressed by the owners. A business that grows very quickly may cause the amount in the buy-sell agreement to be obsolete.
  • Qualifying for life insurance may be difficult for people who have bad health or a family history of early deaths. If a policy can be issued for an unhealthy person, the premiums will be higher. The person owning a policy may be healthy, but he or she owns the insurance on the unhealthy person and the premiums are higher.
  • In addition to health and gender, premiums for life insurance are based on age. Premiums for older owner’s life insurance will be higher. Because of this, there can be a large variance in premium cost between the owners.
  • Life insurance death benefits received by the surviving business owner are subject to claims by creditors of the surviving business owner. Outside of the business activity, a business owner may be having financial difficulty. The proceeds from the insurance are considered a personal asset that can be attached to by personal creditors. The funds that were to be available to buy the business interest from the deceased owner’s heirs may be unavailable for the purchase.
  • With a stock redemption agreement, the premiums for the policies are paid by the company instead of the individual owners. Those with the highest share of ownership in the company effectively pay a larger percentage of the premiums.
  • For a C corporation, insurance death benefits are not taxable but will increase the corporation’s earnings and profits, resulting in taxation when the amounts are distributed to shareholders.
  • Premiums for permanent life insurance are significantly higher than premiums for term-life insurance. Insuring the potential loss by using permanent insurance may be cost prohibitive.