Buy-Sell Agreement

A buy-sell agreement is a legally binding contract among a business's owners, or between the owners and the business, that fixes in advance how an ownership interest will change hands when a defined event happens: an owner's death, disability, retirement, divorce, bankruptcy, or voluntary exit. It names who has the right or obligation to buy the interest, sets or describes how to determine the price, and often arranges funding so the money is there when the event occurs. Its purpose is to keep a business's ownership orderly and to give a departing owner or their heirs a defined market for a share that would otherwise be hard to sell.

Buy-sell agreements come in a few structures, and the choice has real tax and practical consequences. In a cross-purchase agreement, the remaining owners individually buy the departing owner's interest, each often holding a life insurance policy on the others to fund a purchase at death. In an entity or stock-redemption agreement, the business itself buys back the interest, usually funding it with company-owned life insurance. A wait-and-see agreement leaves the choice between those two open until the triggering event. Cross-purchase structures can get unwieldy with many owners, because the number of policies grows quickly; redemption structures are simpler to administer but carry the tax wrinkle below.

Two federal rules shape these agreements. Internal Revenue Code section 2703 governs whether the price set in the agreement is respected for estate-tax purposes. A family-controlled agreement's price binds the IRS only if it meets section 2703(b): it must be a bona fide business arrangement, must not be a device to pass the business to family for less than full value, and must have terms comparable to arm's-length agreements between unrelated parties. If it fails those tests, the IRS can value the interest as if the agreement did not exist. Second, the Supreme Court's unanimous 2024 decision in Connelly v. United States held that a corporation's contractual obligation to redeem a deceased shareholder's stock is not a liability that offsets the value the life-insurance proceeds add to the company. In practical terms, company-owned insurance that funds a redemption can inflate the deceased owner's share value and enlarge the taxable estate. Connelly did not outlaw redemption agreements; it changed the estate-tax math, and it is part of why cross-purchase structures, or special-purpose insurance LLCs that keep the policy outside the operating company, get renewed attention. Because these agreements sit at the intersection of contract, insurance, business, and estate-tax law, they are usually drafted with professional help rather than from a template.

The owners agree on the triggering events, the buyer, the pricing method, and the funding, then sign the contract and put any funding in place, often life insurance sized to each owner's interest. When a trigger occurs, the agreement compels the sale on its stated terms, and the insurance or other funds pay the departing owner or their estate.

A hypothetical example: two equal owners of a business worth $4,000,000 sign a cross-purchase agreement and each buys a $2,000,000 life insurance policy on the other. When one owner dies, the survivor collects $2,000,000 of insurance proceeds and uses them to buy the deceased owner's half from the estate. The estate receives $2,000,000 in cash, the survivor owns the whole business, and because the survivor personally owned the policy, the proceeds are not added to the company's value in the deceased owner's estate the way company-owned insurance can be after Connelly.

Pros

• Gives a departing owner or their heirs a defined buyer and price for an otherwise illiquid interest.
• Keeps ownership orderly and prevents an unwanted co-owner, such as a deceased partner's heirs, from entering the business.
• Life-insurance funding provides ready cash at an owner's death.
• A section 2703-compliant price can fix value for estate-tax purposes.

Cons

• Company-owned insurance funding a redemption can increase the deceased owner's taxable estate after the 2024 Connelly decision.
• A poorly drafted price term may fail section 2703 and be ignored by the IRS.
• Cross-purchase structures grow complex as the number of owners rises.
• The agreement needs periodic review as the business's value and the owners' circumstances change.