Buy-Sell Agreements: Why Every Co-Owned Business Needs One
A buy-sell agreement is a legally binding contract among co-owners that controls what happens to an ownership interest when a triggering event occurs, such as death, disability, divorce, or departure. It sets the price (or the method for determining the price), names who can buy the interest, and establishes a funding mechanism so the buyout can actually happen. Without one, a co-owner’s death or unexpected exit can push remaining owners into a court-supervised dispute, force an unwanted third-party partner into the business, or create a liquidity crisis at the worst possible moment.
What Is a Buy-Sell Agreement and Why Do You Need One?
At its core, a buy-sell agreement answers three questions before a crisis forces the issue: Who can buy a departing owner’s interest? At what price? And how will the buyer pay for it? Co-owned businesses of every size and structure, from two-partner LLCs to multi-shareholder S corporations, benefit from having these answers locked in writing. Absent an agreement, state law and your operating agreement’s default transfer rules fill the gap, often in ways that serve no one well.
The agreement creates certainty for owners, their families, key employees, and lenders who need to know the business will survive a transition. It can also provide a framework the IRS will respect for estate and gift tax valuation purposes, provided it is drafted and maintained correctly.
The Four Common Triggering Events
A well-drafted buy-sell agreement defines the specific events that activate its terms. Most agreements cover four core triggers.
Death
Death is the most straightforward trigger. When an owner dies, the agreement either requires the business or remaining owners to purchase the decedent’s interest, or gives them the option to do so. Life insurance is the most common funding tool. The 2024 U.S. Supreme Court ruling in *Connelly v. United States* (144 S. Ct. 1406) introduced an important wrinkle here: the Court held unanimously that life insurance proceeds held by a corporation to fund a stock redemption must be counted as a corporate asset when valuing the decedent’s shares for estate tax purposes. The insurance money cannot be netted against the redemption obligation. This ruling has prompted many advisors to reconsider entity-redemption structures in favor of cross-purchase arrangements or trust-based ownership of policies.
Disability
Long-term disability can be as disruptive as death, yet many agreements skip it entirely. A disability trigger typically activates after an owner has been unable to work for a specified period, often 12 to 24 months. Disability buyout insurance is available to fund these purchases, though premiums are meaningful and underwriting can be strict for older or less healthy owners.
Departure or Resignation
When an owner voluntarily leaves, the agreement typically gives the remaining owners a right of first refusal to purchase the departing owner’s interest before it can be sold to an outside party. Many agreements distinguish between a voluntary resignation and a termination for cause, applying different price formulas or discount mechanisms to each.
Divorce
Without a restriction on transfer, a divorcing owner’s interest could end up in the hands of an ex-spouse through a property settlement. Most buy-sell agreements prohibit that outcome by granting the business or remaining owners the right to purchase any interest that a family-court proceeding would otherwise transfer to a non-owner.
Types of Buy-Sell Agreements
Three structural approaches are used most often. The right choice depends on the number of owners, entity type, tax status, and how the purchase will be funded.
Entity Redemption (Stock Redemption)
In a redemption agreement, the business itself agrees to purchase the departing owner’s interest. The company owns one life insurance policy per owner, collects the death benefit, and uses it to fund the purchase. Administration is simpler than a cross-purchase because fewer policies are involved. The post-*Connelly* tax consequence is the primary drawback: life insurance proceeds increase the company’s value, which can raise the estate tax exposure for the decedent’s estate. Businesses with total equity values well below the 2026 federal estate tax exemption of $15 million per person (as established by the One Big Beautiful Bill Act, indexed for inflation from 2027 onward) may find this risk manageable, while larger businesses may not.
Cross-Purchase Agreement
In a cross-purchase, each owner purchases and owns a life insurance policy on each other owner. When one owner dies, the surviving owners collect the death benefit and use it to buy the decedent’s interest directly. The *Connelly* problem does not arise because the insurance proceeds belong to the surviving owners personally, not the business. The surviving owners also receive a step-up in basis to the purchase price, which reduces capital gain exposure when they eventually sell their interests. The administrative burden scales poorly as the owner count rises: a business with five owners requires 20 separate policies.
Hybrid (Wait-and-See) Agreement
A hybrid agreement gives both the business and the remaining owners a sequential right to purchase, with the trigger event determining who acts first. This approach preserves flexibility but requires careful drafting so that the option periods do not create gaps that leave an interest in limbo.
The Buy-Sell Valuation Clause: Getting the Price Right
The buy-sell valuation clause is often the most contested provision in the entire agreement. Three approaches are common.
Fixed price. The owners agree to a stated dollar amount and commit to reviewing and updating it on a defined schedule, typically annually. Fixed-price provisions work only if owners actually perform those updates. An agreement with a stale fixed price from five years ago will almost certainly fail to reflect current value and can trigger disputes or IRS scrutiny.
Formula price. The agreement specifies a formula, such as a multiple of EBITDA or a book-value calculation, that is applied at the time of the triggering event. Formula approaches update automatically with the business’s financials but can produce results that diverge significantly from what a willing buyer and seller would actually negotiate.
Appraisal. A qualified independent appraisal at the time of the triggering event produces the most defensible number, especially for estate and gift tax purposes. Many agreements use a two-appraiser method, with each party selecting an appraiser and the two appraisers naming a third if the two valuations differ by more than a stated threshold.
IRS Safe Harbor Under IRC Section 2703
A buy-sell agreement can serve as the binding price for estate and gift tax purposes only if it satisfies all three conditions of the safe harbor under IRC Section 2703(b). First, the arrangement must be a bona fide business arrangement. Second, it must not be a device to transfer property to family members for less than full and adequate consideration. Third, its terms must be comparable to those in arm’s-length transactions between unrelated parties. An agreement that fails any one of these tests will be disregarded for estate tax purposes, and the IRS can substitute its own valuation of the transferred interest. Engaging a qualified business valuator when drafting or significantly amending the agreement is the clearest way to demonstrate comparability.
Funding the Buyout
An agreement that requires a $5 million buyout is only as good as the cash available to execute it. The four primary funding methods each involve tradeoffs.
Life insurance provides an immediate, tax-free death benefit at the moment it is most needed. As noted above, the structure of ownership (entity versus individual) now carries meaningful estate tax implications following *Connelly*.
Disability buyout insurance covers the long-term disability trigger. Policies typically begin paying after a defined elimination period and may be structured to pay a lump sum or in installments.
Installment payments allow a buyer to pay the purchase price over time from business earnings, with the seller (or the seller’s estate) accepting a promissory note. The interest rate must meet IRS applicable federal rate (AFR) requirements to avoid imputed interest complications. Installment sales also expose the seller to collection risk if the business declines after the transition.
Sinking fund arrangements have the business or owners set aside liquid reserves over time. This approach avoids insurance premiums but ties up capital and requires discipline over many years.
Estate Planning Intersection
The federal estate and gift tax exemption stands at $15 million per person in 2026 under the OBBBA, making estate tax a concern only for larger estates. Even so, the buy-sell agreement’s valuation provisions interact directly with estate planning for owners of significant businesses, and a mispriced or disqualified agreement can generate an unexpected estate tax bill.
The Tax Adviser article on buy-sell agreement valuation outlines how agreements must meet the Section 2703 safe harbor to be respected for estate tax purposes. Coordinating with both a business attorney and a tax advisor when drafting or updating an agreement is essential. Modus’s transaction advisory team regularly works alongside legal counsel on these provisions.
Common Mistakes to Avoid
Drafting the agreement but never funding it. An unfunded agreement is a plan without a budget. Review life insurance coverage and sinking fund balances at least every two years to verify the funding will cover the current value of the interests.
Stale fixed prices. If owners choose a fixed-price approach, calendar annual review meetings and document the agreed update in writing. A price that hasn’t been reviewed in several years is an invitation for litigation.
Ignoring the *Connelly* implication. Businesses with entity-redemption structures using company-owned life insurance should review whether the estate tax exposure created by *Connelly* is meaningful given current business value and the applicable estate tax exemption. In many cases the post-*Connelly* risk is modest; in others, restructuring to a cross-purchase or an irrevocable life insurance trust (ILIT) to hold policies may be warranted.
Failing to update after ownership changes. A new partner entering the business, a partial buyout, or a restructuring event all require the agreement to be revisited and potentially rewritten. An agreement drafted for three equal owners is likely to produce the wrong result after one owner’s interest is redistributed.
Not aligning the agreement with the operating documents. Restrictions in the buy-sell agreement must be consistent with the company’s operating agreement, partnership agreement, or corporate bylaws. Conflicting provisions create ambiguity that courts resolve unpredictably.
A well-maintained buy-sell agreement is a core element of any sound business succession plan. Modus’s advisory services and tax team support business owners in designing, reviewing, and keeping current the financial and tax dimensions of these arrangements as part of broader succession and transaction planning.
Frequently Asked Questions
What is a buy-sell agreement and who needs one?
A buy-sell agreement is a contract among business co-owners that sets the rules for transferring an ownership interest when a triggering event occurs, such as death, disability, or voluntary departure. Any business with two or more owners benefits from having one. Without an agreement, state default law or ambiguous operating-agreement language governs what happens, often leading to litigation or forced transactions.
Does a buy-sell agreement fix the value of my business for estate tax purposes?
Only if the agreement satisfies the three-part safe harbor under IRC Section 2703(b): it must be a bona fide business arrangement, not a device to shift value to family members below fair market value, and its terms must be comparable to arm’s-length transactions. An agreement that fails any of those tests will be ignored by the IRS for estate tax purposes, which can produce a valuation significantly higher than the agreed price.
How did *Connelly v. United States* change buy-sell planning?
In June 2024, the U.S. Supreme Court ruled unanimously that life insurance proceeds held by a corporation to fund a stock redemption are counted as a corporate asset in valuing the deceased owner’s estate, not netted against the redemption obligation. This raised the effective estate tax exposure in entity-redemption (stock-redemption) structures funded with company-owned life insurance. Business owners with these structures should review whether the *Connelly* ruling creates a meaningful tax concern given their current business value and estate size.
What are the main ways to fund a buy-sell agreement?
The four primary methods are life insurance (provides immediate cash at death), disability buyout insurance (covers long-term disability), an installment sale arrangement funded from future business earnings, and a sinking fund of accumulated reserves. Most advisors recommend life insurance for death-trigger coverage because the proceeds arrive when needed, are income-tax-free to the recipient, and are predictable in amount. The ownership structure of the insurance (individual cross-purchase versus entity-owned) affects the estate tax outcome.
How often should a buy-sell agreement be reviewed?
At minimum, review the agreement whenever the business experiences a significant change, including a change in ownership, a major shift in business value, a new financing arrangement, or the entry or exit of any owner. Even without such events, a review every two to three years is sound practice to verify that the valuation method, insurance coverage levels, and triggering-event definitions remain accurate and current.
Can a buy-sell agreement be used in a partnership or LLC, or only in a corporation?
Buy-sell provisions apply to any co-owned entity, including general and limited partnerships, limited liability companies, and corporations. The structural mechanics differ slightly: corporate buy-sells deal with shares, LLC buy-sells deal with membership interests, and partnership agreements address partnership interests. The IRC Section 2703 safe-harbor rules apply across all entity types for estate and gift tax purposes.
Filed under: Transaction Advisory