How does a buy-sell agreement funded with life insurance work?

A buy-sell agreement funded with life insurance is a legally binding contract among the co-owners of a business that decides, in advance, exactly what happens to an owner's share if that owner dies — and it uses a life insurance policy to provide the cash needed to complete the purchase. When an owner dies, the income-tax-free death benefit is paid, and that money is used by the surviving owners or by the business itself to buy the deceased owner's interest from their estate at a price the owners agreed to ahead of time. The family walks away with a fair, liquid payout instead of being stuck with a stake they cannot easily sell, and the surviving owners keep full control of the company they built. It is one of the most important pieces of planning a self-employed business owner with partners can put in place.

Why a business needs a buy-sell agreement in the first place

Without an agreement, the death of a co-owner can throw a healthy small business into chaos. Ownership does not simply vanish — it passes to whoever inherits it.

• The deceased owner's shares pass to their heirs (a spouse, children, or an estate) who may know nothing about running the business and may not want to.
• The surviving owners suddenly have a new co-owner they never chose — or they have to scramble to buy that person out with no agreed price and no ready cash.
• The family usually needs money, not an illiquid minority interest, and may pressure the survivors to sell the whole company just to cash out.

A properly drafted buy-sell fixes four things in writing before any of that can happen: who is allowed to buy, who is required to sell, at what price (or how the price is calculated), and where the money to pay for it comes from. The first three are the lawyer's job. The fourth — the funding — is where life insurance comes in.

Why life insurance is the funding of choice

An agreement that says “the survivors will buy the shares” is only as good as the cash standing behind it. Owners have a handful of ways to fund a buyout, and most of them are painful:

• Pay cash — few businesses have a six- or seven-figure sum sitting idle for the day an owner dies.
• Borrow it — a bank may be reluctant to lend right at the moment a key owner has just died and the business looks shaky.
• Pay in installments — the family waits years for their money while the survivors carry the debt out of future profits.
• Life insurance — the one option built for the exact event that triggers the buyout.

Life insurance is uniquely suited to this job because the event that triggers the purchase — a death — is the same event that pays the policy. For a comparatively small premium, a tax-free lump sum arrives precisely when it is needed. The death benefit is generally received income-tax-free under Internal Revenue Code Section 101(a)(1), so the full face amount is available to fund the purchase rather than being eroded by income tax. That combination of certainty, timing, and tax efficiency is why funded buy-sells are almost always insurance-funded.

The three ways to structure it

There are three classic structures, and the difference between them is who owns the policies. That single choice drives the tax result, the paperwork, and — since 2024 — the estate-tax exposure.

Cross-purchase

Each owner personally buys and owns a life insurance policy on each of the other owners. When an owner dies, the surviving owners collect the death benefit and use it to buy the deceased owner's interest directly from the estate.

• Advantage: the buyers get an increase in their cost basis in the shares they purchase, which can reduce capital-gains tax if they sell the business later. The insurance proceeds never touch the company's books.
• Drawback: the number of policies multiplies as owners are added. With n owners you need n × (n − 1) policies — two owners need 2 policies, but four owners need 12. Differences in owners' ages and health also make premiums uneven.

Cross-purchase reflects the broader role of life insurance for the self-employed — each partner insures the others so the money is there to buy them out.

Entity purchase (stock redemption)

The company itself owns one policy on each owner and is the beneficiary. When an owner dies, the company collects the proceeds and redeems — buys back — the deceased owner's shares.

• Advantage: it is administratively simple — one policy per owner, one premium payer, and easy to manage as owners come and go. This is why many businesses historically chose it.
• Drawbacks: the surviving owners get no basis step-up from a redemption, and — critically after 2024 — the company-owned insurance can inflate the business's value for federal estate tax. Because the policies are owned by the company, this is a form of corporate-owned life insurance, and it now carries the Connelly wrinkle described below.

Wait-and-see

A hybrid that postpones the choice. Typically the surviving owners get the first option to buy the shares, and whatever they decline, the entity redeems. It keeps flexibility, but it is not a magic escape hatch: the family in the Connelly case itself had what amounted to a wait-and-see arrangement that defaulted to a company redemption — which is exactly what caused the tax problem.

The 2024 Connelly decision every owner must know

In Connelly v. United States, decided June 6, 2024, a unanimous U.S. Supreme Court (opinion by Justice Thomas) reshaped the math on entity-redemption buy-sells. Two brothers owned a building-supply company, Crown C Supply, and the company held $3.5 million of life insurance on each brother to fund a redemption. When one brother died, the IRS argued — and the Court agreed — that the deceased brother's shares had to be valued with the insurance proceeds counted as a company asset.

The holding: a corporation's contractual obligation to redeem a deceased shareholder's shares at fair market value is not a liability that reduces the corporation's value for federal estate-tax purposes. Company-owned life insurance earmarked for the redemption counts as a corporate asset that increases the company's fair market value — with no offset for the obligation to spend that money buying the shares.

In plain English: the life insurance the company held to fund the buyout also counted as a company asset that raised the business's value dollar-for-dollar — with no offset for the obligation to spend that money buying the deceased owner's shares. The same roughly $3.5 million of insurance that was about to leave the company to pay for those shares first made the company look millions of dollars more valuable for estate-tax purposes. That can push an owner's estate into, or higher within, federal estate tax.

The Court itself pointed to the fix. It noted the brothers “could have used a cross-purchase agreement,” with the owners rather than the company holding the policies, to avoid the result. Since the decision, advisors have moved in two directions:

• Cross-purchase agreements for new arrangements, keeping the insurance out of the company entirely.
• A special-purpose insurance LLC — a separate, partnership-taxed LLC that owns the policies. It keeps the proceeds off the operating company's balance sheet, fits within the partner/partnership exceptions to the transfer-for-value rule, and still delivers a basis step-up much like a cross-purchase, while avoiding the policy-count headache of a large cross-purchase.

If you already have an entity-redemption buy-sell funded with company-owned insurance, it deserves a fresh review. The same valuation logic that raised the estate-tax value in Connelly can also distort the buyout price itself.

Term or permanent life insurance to fund it?

Both work; the right choice depends on how long the buyout obligation will last.

• Term life insurance is the low-cost choice when the obligation has a defined horizon — for example, partners who plan to sell or wind the business down within the next 10 to 30 years. It supports a large death benefit at a modest premium, but it has no cash value and must be renewed or replaced if the need outlives the term.
• Permanent life insurance (whole life or universal life) fits a lifelong obligation, a planned lifetime or retirement buyout, or a situation where the policy's cash value is wanted to help fund a living buyout — an owner who retires rather than dies. Permanent premiums commonly run several times the cost of comparable term coverage, so it suits established owners with stable cash flow.

Many owners blend the two: term for the bulk of the death-benefit need while the business is growing, with a permanent layer for the portion of the obligation that will still exist at retirement. For a fuller look at how these coverage types serve an owner's whole plan, see our guide to life insurance for business owners.

How a funded buy-sell is taxed

This is educational information, not tax advice — but a few rules matter enough that every owner should know them going in.

• The premiums are not tax-deductible. Because the owner or the business is the beneficiary of the policy, Internal Revenue Code Section 264(a)(1) disallows a deduction for buy-sell premiums. Do not plan around a write-off that does not exist.
• The death benefit is generally income-tax-free to whoever receives it, under Section 101(a)(1). That is what makes the full face amount available to fund the purchase.
• Watch the transfer-for-value rule. If an existing policy is sold or transferred for value to the wrong party, part of the death benefit can lose its tax-free status. There are safe exceptions — transfers to the insured, to a partner of the insured, to a partnership the insured is part of, or to a corporation in which the insured is a shareholder or officer. This is precisely why restructuring an existing buy-sell (for example, moving policies from an entity plan to a cross-purchase, or into an insurance LLC) must be done carefully with a tax advisor. A careless transfer can trigger an unexpected tax bill.

A funded buy-sell is different from key person insurance, which reimburses the business for the financial loss of a vital owner or employee rather than buying out anyone's shares. Owners frequently carry both, for two different jobs.

Getting the amount and the price right

Funding is only useful if it matches the real value of what is being bought.

• Size the coverage to each owner's share, not a guess. Fund too little and the survivors still have to come up with the shortfall; fund far too much and premium dollars are wasted.
• Set a clear valuation method in the agreement — a fixed price updated periodically, a formula, or an independent appraisal at death — so the family and the surviving owners are not fighting over “what is it worth” during the worst week of everyone's year.
• Review the coverage as the business grows. A policy sized to a $1 million company is badly short once the business is worth $4 million. Build in a way to raise the coverage over time so the funding keeps pace.

Common mistakes owners make

• A beautifully drafted agreement with no policy behind it — all promise, no cash.
• Coverage that never kept pace with the company's growth.
• An old entity-redemption structure nobody has revisited since the Connelly decision.
• Policies owned by the wrong party, quietly creating a transfer-for-value problem.
• The wrong beneficiary named, so the money does not land where the agreement assumes it will.
• Treating the premiums as a deductible business expense (they are not).

North Carolina and the 2026 estate-tax picture

For a Charlotte-area business owner, the state-tax news is good and the federal picture is important context:

• North Carolina repealed its state estate tax in 2013 and has no inheritance tax, so only the federal estate tax can ever reach an NC owner's estate.
• For 2026, the federal estate-tax exemption is $15 million per person — made permanent by the 2025 One Big Beautiful Bill Act, with inflation indexing resuming in 2027. With portability, a married couple can shelter roughly $30 million. The top federal estate-tax rate is 40%.

The practical read: most small-business owners sit comfortably under the exemption, so the Connelly valuation bump will not create an actual estate-tax bill for them. But owners whose business value plus insurance approaches the exemption — and any owner who wants the price and basis treatment to work exactly as intended — should structure the funding deliberately rather than by default.

Talk it through with The Jordan Insurance Agency

A buy-sell agreement is a legal document your attorney drafts, and the tax treatment belongs to your CPA — but the funding is our specialty. The Jordan Insurance Agency is an independent agency based in Charlotte, North Carolina, and because we work with multiple life insurance carriers, we can shop the right amount and type of coverage — term, permanent, or a blend — across companies to fit your agreement and your budget, instead of being limited to a single carrier's rates and underwriting.

If you already have a buy-sell in place, we are glad to help you check whether the funding still matches your business's value and whether an older entity-redemption structure deserves a fresh look after Connelly. If you are starting from scratch, we can coordinate with your attorney and CPA so the policies match the plan. There is no cost to talk it through — reach out and we will help you make sure the money is there when your business needs it most.

This page is educational only and is not tax or legal advice. Confirm any tax or legal step with your CPA or attorney before you act.