Buy-Sell Agreement Tax Design

How it works

A buy-sell agreement is a contract, among the owners, or between the owners and the entity, or both, that obligates or gives an option for a sale of an owner's interest on a triggering event: death, disability, divorce, retirement, or a dispute-driven exit. Its job is to keep the business with people who want to run it and to guarantee the departing owner, or their estate, actually gets paid.

The single choice that matters most is the structural form, because it decides who ends up with a basis step-up.

• Entity redemption. The entity buys back the departing owner's interest. The remaining owners never touch the basis in their own interests; they did not buy anything. The company is simply smaller, and the survivors own a larger share of the same historical basis they already had.
• Cross-purchase. The other owners buy the departing owner's interest directly. Under Section 1012's cost-basis rule, each buyer gets a real, dollar-for-dollar basis step-up in the interest acquired, on top of the basis in their own original interest.
• Hybrid, or "wait-and-see." The entity gets a first option to redeem, with the remaining owners as a fallback personal buyer, or the reverse. The transaction's actual character is settled only at the triggering event, based on who actually buys, which keeps both paths open at the cost of drafting complexity and real uncertainty about which regime ends up governing.

Entity type changes the tax character of the payout, capital gain, dividend, or ordinary income, on top of the redemption-versus-cross-purchase question:

How the payout is taxed, by entity

How this gets funded

Life insurance is the default financing choice because it produces cash exactly when it is needed, at death, and Section 101(a)(1) excludes that death benefit from income entirely. Who owns the policy, the entity or the individual co-owners, decides whether a 2024 Supreme Court ruling on estate valuation applies at all, and whether the payout stays tax-free once it arrives.

The Florida piece

Florida has no individual income tax, so any capital gain a departing owner or their estate recognizes on a sale is a federal number only. Florida also has no estate or inheritance tax: the state constitution caps any state-level estate tax at the federal state-death-tax credit, and Congress phased that credit to zero by 2005. Everything below lives entirely in the federal system.

Who this applies to

This needs at least two owners, and that requirement does most of the filtering. A sole owner has no buy-sell counterparty; this is a business-succession problem, not a household deduction.

• Any multi-owner closely held entity. A C corporation, an S corporation, a partnership, or a multi-member LLC. All four can use any of the three structural forms above; what changes is the tax character of the payout, not whether the design is available.
• Family-owned and closely held businesses face sharper estate-tax scrutiny. The safe harbor that automatically satisfies all three prongs only applies when more than half the value of the property subject to the restriction is owned by people outside the transferor's family, bound by identical terms. A two-sibling company, or a parent selling to a child, gets no safe harbor and has to satisfy all three prongs independently.
• C corporation shareholders need their family-attribution picture before assuming a redemption will qualify for capital-gain treatment. Stock owned by a spouse, child, grandchild, or parent, though not a sibling, attributes back to the departing shareholder, and it can quietly convert what looks like a complete exit into a dividend.
• S corporation shareholders need the price set at fair value, at book value, somewhere between the two, or tied to death, divorce, disability, or termination of employment. Anything else opens a narrow but real risk to the S election.
• Partners and LLC members need to know upfront whether an exit is the partnership itself liquidating the departing interest, or another partner buying it directly. The two paths tax the identical economic event in completely different ways.

What it requires

A handful of conditions have to be met independently, or the structure fails on audit, or leaves protection on the table the owners thought they had.

• A deliberate structural choice. Redemption is administratively simpler, one set of policies, one buyer, but it permanently gives up the survivors' basis step-up and, for a corporation, now carries the estate-tax cost described below. Cross-purchase keeps the step-up and keeps proceeds off the entity's balance sheet, but multiplies the policies needed once there are three or more owners and creates affordability gaps when owners are different ages or health risks.
• An agreement that survives Section 2703. The IRS can disregard a buy-sell's stated price entirely unless the agreement is a bona fide business arrangement, is not a device to transfer value to family for less than full consideration, and has terms comparable to an arm's-length deal. All three, independently, short of the family-ownership safe harbor above.
• A pricing mechanism that actually gets revisited. A fixed price set once and never updated is the single most common reason these agreements fail on audit. The agreement needs a mandatory, periodic re-pricing mechanism built in: an annual appraisal, a formula recalculated on a schedule, or a named appraiser who steps in automatically if the owners fail to agree on a number.
• An insurance ownership decision made before the policy is bought. Converting an existing policy from entity to co-owner ownership can trigger the transfer-for-value rule and turn a tax-free death benefit into taxable income above basis, because Section 101(a)(2)(B) has no exception for a transfer to a co-shareholder. The reverse direction is safe: that same provision excepts a transfer to a corporation in which the insured is a shareholder or officer, so moving a cross-purchase policy to the entity does not taint the proceeds. Issuing new policies in the correct ownership pattern from the start avoids the question entirely.
• Notice-and-consent paperwork completed before an employer-owned policy issues. Written notice of the intent to insure and the coverage amount, the employee's written consent, and written notice that the employer will be a beneficiary all have to happen before the policy is issued. This cannot be fixed after the fact.
• A redemption policy sized for the right number. Since Connelly, an entity-owned policy has to be sized against the company's value after the death benefit is added, not a percentage of the value beforehand. The proceeds themselves become part of what the corporation is redeeming against.

What you need to document

An audit tests the paper trail as much as the tax position, and most of what follows has to be created as things happen rather than reconstructed afterward.

A live valuation record

The actual appraisal, formula calculation, or agreed number for each re-pricing date, not just the figure the agreement started with.

The insurance notice-and-consent file

Written notice to the insured employee before the policy issues, their written consent, and written notice that the entity will be a beneficiary. Then, every year the policy is in force, a filed Form 8925 reporting coverage and confirming consent was obtained.

The Florida transfer-restriction notice

For a corporation, the share-transfer restriction has to be conspicuously noted on the stock certificate or the information statement, or it is unenforceable against a holder who does not know about it. An LLC has no statutory backstop; the operating agreement itself is the entire source of the restriction.

The elections actually filed

An S corporation closing-of-the-books election on a complete termination, so the departing shareholder is not taxed on income earned after they left. A partnership's inside-basis adjustment election, so a transfer or a liquidating distribution can correct the partnership's basis.

Where it goes wrong

The most consequential recent development here is not a planning technique. It is a loss.

Connelly v. United States

Michael and Thomas Connelly were the only two shareholders of Crown C Supply, a closely held Missouri corporation. Their agreement required Crown to redeem a deceased brother's shares if the survivor declined to buy them personally, and Crown carried $3.5 million of life insurance on each brother to fund that obligation. When Michael died, Crown used $3 million of the proceeds to redeem his 77.18 percent stake. The estate's own accountant valued the company by excluding the insurance proceeds entirely, on the theory that Crown's redemption obligation offset them, arriving at a company value of $3.86 million. The IRS added the proceeds back, valued the company at $6.86 million instead, and assessed an additional $889,914 of estate tax.

The Supreme Court sided with the IRS, unanimously, in June 2024. A corporation's contractual obligation to redeem a deceased shareholder's stock at fair market value, funded by insurance proceeds already on hand, does not offset the value of those proceeds when valuing the shares for federal estate-tax purposes, even though the company will pay the obligation out of those very proceeds. The holding is narrower than it first sounds: redemption obligations are not necessarily liabilities that reduce a corporation's value, and the Court expressly declined to hold that one can never do so, noting that a redemption obligation could instead require a corporation to liquidate operating assets to pay for the shares and so reduce its future earning capacity. The Court rejected the offset theory the estate's accountant relied on, and named the alternative the brothers had not used: a cross-purchase, where the proceeds would have gone straight to the surviving brother and never touched the corporation's value. It also named the cost of that path: paying premiums on a policy covering the other brother, with the risk that one of them could not keep up.

The recurring mistakes

• Missed insurance notice-and-consent. If the written notice and consent were not obtained before an employer-owned policy issued, the exclusion collapses to premiums paid, and the shortfall shows up as taxable income exactly when the money is needed to fund the redemption.
• Moving an existing policy between owners. There is no exception for a transfer to a co-shareholder, so restructuring a redemption plan into a cross-purchase with an already-issued policy can convert a future tax-free benefit into taxable income above basis.
• An unwaived family-attribution problem. A departing shareholder whose spouse or child still holds stock can find an intended complete exit recharacterized as a dividend: ordinary income, with no basis recovery until the corporation's earnings are exhausted.
• The goodwill default in a service partnership. A retiring general partner gets ordinary income on goodwill automatically unless the partnership agreement affirmatively says otherwise, quietly converting an expected capital gain into ordinary income.
• An installment-paid buyout with hot assets. A retirement or disability exit is often paid over time, since insurance funding only exists for the death trigger. If the partnership holds unrealized receivables or inventory items, and on a sale of an interest there is no substantial-appreciation threshold to clear, the recapture-driven share of the gain cannot ride the payment schedule; it is recognized in full in the year of sale, the acceleration rule I cover for a straight buyout in installment sales, and for a direct sale of assets rather than a partnership interest, in earnouts and rollover equity.

A situation where this comes up

The pattern I see most often is two or three unrelated owners of an S corporation whose buy-sell agreement was drafted when the entity was formed and has not been touched since. The price is whatever the attorney's template defaulted to, the insurance was bought to satisfy a lender's checklist, and nobody has revisited either one as the business grew. Redemption was chosen because it is administratively simpler, one set of policies instead of three or four, without anyone weighing what the survivors give up in exchange.

What usually has to change is not the business. It is the paperwork, and the structural decision behind it. For most owners, the total value of what they will eventually leave behind is nowhere near the federal estate and gift tax exemption, which recent federal legislation set at $15 million per person for 2026, so the Section 2703 valuation fight and the Connelly insurance-proceeds question never actually arise. What almost always matters more commercially is the basis-step-up question: whether the eventual buyer of the whole company inherits a low, decades-old basis or a real cost basis in what they bought.

The version that concerns me is the one where the structure was never really decided at all, just inherited from a template, and a triggering event arrives before anyone has looked at it again.