Life Insurance in Buy-Sell Agreements: Cross-Purchase vs. Entity Purchase

When two or more people own a business together, a funded buy-sell agreement is one of the most important documents they'll sign — and one of the most commonly left incomplete. A buy-sell agreement specifies what happens to each owner's interest when a triggering event occurs (death, disability, retirement, divorce, or voluntary departure). Life insurance is one of the most common mechanisms for funding the buy-sell obligation at death, because it converts an illiquid business interest into cash at exactly the moment the business needs cash.

The structure of how that life insurance is owned — by the entity itself or by the individual owners through a cross-purchase arrangement — has significant tax, basis, and practical consequences. This article walks through the mechanics of each approach, the specific trade-offs, and the situations where each structure fits.

Before getting into insurance structure, clarify what the buy-sell is solving for.

When an owner dies, their interest passes to their estate. In the absence of a buy-sell agreement:

• The deceased's heirs (spouse, children) become co-owners with the surviving partners
• The heirs often have no interest in operating the business and no expertise doing so
• The surviving owners face ongoing obligations to heirs who are now partners
• The estate may need liquidity from the business interest to pay estate taxes and meet family needs

A funded buy-sell agreement converts this situation: the business interest passes to the estate at death, then the estate sells it to either the business or the surviving owners (per the agreement), receiving cash. Surviving owners receive the deceased's ownership interest. Everyone gets what they actually want — heirs get cash, survivors get clean ownership.

Life insurance funds the cash that flows to the estate. Without funded insurance, survivors often can't afford to buy out the estate, and the buy-sell agreement becomes a document rather than a mechanism.

Entity Purchase (Stock Redemption)

The entity (corporation or LLC) owns life insurance policies on each owner. The entity is the policyholder, pays the premiums, and is the beneficiary. When an owner dies, the entity receives the insurance proceeds and uses them to redeem (buy back) the deceased owner's interest from the estate.

Mechanics: - Business entity owns policies on each owner - Policies are business assets on the entity's books - Premiums are paid by the entity (not tax-deductible as insurance premiums generally) - Death proceeds flow to the entity (generally tax-free under Section 101, though C corps face potential Alternative Minimum Tax implications that have evolved) - Entity uses proceeds to redeem deceased owner's shares - Deceased owner's interest is cancelled (corporation) or terminated (LLC/partnership) - Surviving owners' percentage increases mechanically

Cross-Purchase

The individual owners own policies on each other. Owner A owns a policy on Owner B, and Owner B owns a policy on Owner A (and if there's an Owner C, A owns a policy on C, B owns a policy on C, and C owns policies on A and B).

Mechanics: - Each owner personally pays premiums on policies owned on other owners - Policies are personal assets of the policyholder - Death proceeds flow to the surviving owner personally (generally tax-free) - Surviving owners personally use proceeds to purchase deceased owner's interest from the estate - Surviving owners acquire additional ownership, with basis equal to what they paid

This is the central reason cross-purchase often beats entity purchase for the survivors.

In entity purchase: The entity redeems the deceased's stock. The surviving owners' basis in their existing shares is unchanged. They own a larger percentage of the company, but their tax basis reflects only their original investment. When they eventually sell their own interests later, they'll recognize gain reflecting full appreciation — including appreciation on the interest they effectively acquired through the redemption.

In cross-purchase: The surviving owners personally buy the deceased's interest using the insurance proceeds. Their basis in their new ownership equals the purchase price paid — which is the current fair market value (typically the insurance proceeds amount). When they later sell, their basis reflects this purchase, reducing taxable gain.

Over a long holding period with appreciating business value, this basis difference can translate to hundreds of thousands of dollars in eventual tax savings.

A worked example: Three equal partners own a business worth $3 million (each worth $1 million). Each partner has $100,000 basis in their interest.

Partner A dies. Life insurance of $1 million funds the buyout.

Entity purchase: Entity receives $1M insurance, pays $1M to A's estate, cancels A's shares. Partners B and C now each own 50% of the company. Their basis is unchanged at $100,000 each.

Cross-purchase: B and C each receive $500,000 insurance (from policies owned on A), and each uses it to buy $500,000 worth of A's estate's interest. Each now owns 50%. Their basis increases by $500,000.

Fast forward 5 years. Business is worth $5M. B and C sell for $2.5M each.

After entity purchase: B and C each recognize $2.4M gain ($2.5M minus $100K basis).

After cross-purchase: B and C each recognize $1.9M gain ($2.5M minus $600K basis).

At 20% long-term capital gains, cross-purchase saves each surviving partner $100,000 in tax at eventual sale. For a closely-held business, this is meaningful.

Despite the basis disadvantage, entity purchase has real advantages in specific situations:

Multiple partners. With three partners, cross-purchase requires 6 policies (A on B and C, B on A and C, C on A and B). With four partners, it requires 12 policies. The administrative complexity and premium cost grows quickly. Entity purchase requires only one policy per partner regardless of the number of partners.

Large age or health differentials among partners. In cross-purchase, each partner pays premiums based on the insured's age and health. If Partner A is much older or less healthy than Partner B, B's premium burden (insuring A) is much higher than A's (insuring B). This disparity can be addressed by salary adjustments or other mechanisms, but it creates complication.

Policy administration. Entity purchase puts all policies in one place, under business ownership and business record-keeping. Cross-purchase distributes policies among individual owners, with each owner responsible for their policies. Records get lost. Payments get missed. The coordination burden is real over 20+ year policy lives.

Certainty of premium payment. Business-owned policies have premiums paid from business accounts. Cross-purchase policies depend on individual owners paying premiums from personal funds. Individual owners facing personal financial stress may skip premium payments, compromising the entire buy-sell funding.

Estate tax considerations. Under complex rules, life insurance proceeds can be included in the insured's taxable estate in certain circumstances. The specific structure affects this. Generally, entity-owned insurance has cleaner estate exclusion than cross-purchase under some fact patterns, but the specific analysis depends on estate planning specifics.

S corp specific issues. S corps have single-class-of-stock rules that constrain how distributions and redemptions work. Entity-purchase structures that affect only one class work cleanly. Cross-purchase may work well for S corps but the specific tax mechanics require attention.

Basis isn't valuable if the business won't be sold. If surviving owners plan to hold the business until their own deaths (receiving step-up in basis at their death), the cross-purchase basis advantage never matters. The step-up at later death eliminates the gain that cross-purchase would have mitigated.

For partnerships and LLCs taxed as partnerships, the analysis differs from corporations in specific ways.

Section 754 election. A partnership can make a Section 754 election that allows basis adjustments on the death of a partner. When this election is in place, even an entity-purchase structure can produce basis step-up for the remaining partners (through adjustments to the basis of partnership assets). This can materially reduce the basis-advantage-of-cross-purchase argument for partnerships.

Section 736 payment classification. In partnership buyouts at death, payments can be classified as either payments for partnership property (Section 736(b)) or payments for unrealized receivables/goodwill/guaranteed payments (Section 736(a)). The allocation affects who gets what tax treatment. Buy-sell agreements can specify the allocation, within limits.

Lack of simple stock-redemption concept. Partnerships and LLCs don't have "stock" in the technical sense; interests are "units" or "membership interests." The redemption vs. cross-purchase concept still applies, but the mechanics follow partnership taxation rather than corporate rules.

For partnerships with meaningful appreciated assets and long-term holding intent, the Section 754 election may deliver substantial basis benefits regardless of buy-sell structure, making entity purchase more attractive than in corporate contexts.

Section 101 generally makes life insurance death proceeds tax-free — whether the beneficiary is an individual, a corporation, a partnership, or a trust. There's broad exclusion regardless of structure.

However, specific issues apply:

C corporations and AMT. Historically, life insurance proceeds were a preference item for corporate AMT, which could tax a portion of the proceeds at corporate AMT rates. This issue has been modified significantly in recent tax legislation and the practical impact has diminished, but any C corp using entity-owned life insurance should confirm current AMT treatment with tax counsel.

Transfer-for-value rule. Under Section 101(a)(2), if a life insurance policy is transferred for valuable consideration, the death proceeds can lose their tax-free status (becoming taxable as ordinary income to the extent they exceed basis). This trips up transactions where policies are moved among owners, trusts, or entities. Exceptions exist for transfers to the insured, partner of the insured, partnership in which the insured is a partner, and corporation in which the insured is an officer or shareholder. Any policy transfer should be analyzed against this rule.

Estate inclusion. If the insured owned the policy or had "incidents of ownership" at death, the death proceeds may be included in the insured's taxable estate. For an owner-employee who is 100% shareholder of a corporation that owns a policy on their life, there's some risk of constructive ownership. Entity purchase structures generally avoid this if the corporation is a separate legal entity and the insured doesn't individually control policy decisions.

Basis in policies. The entity or individual has tax basis in policies equal to cumulative premiums paid (for non-investment-component policies) or the policy's cash value. Surrender or sale before death can produce taxable gain.

For most straightforward situations, life insurance proceeds are tax-free and the structural choice comes down to basis step-up and administrative factors rather than tax characterization of proceeds.

A buy-sell agreement funded with inadequate insurance is almost worse than no buy-sell at all — the agreement creates an obligation that can't be met with available cash. Common underfunding patterns:

Original amount never updated. Businesses grow. An insurance policy purchased 10 years ago for $500,000 might be dramatically inadequate today if the business is worth $3M.

Insurance covers only original cost basis, not current value. Some buy-sells specify insurance at a "book value" or "original investment" level, not current fair market value.

Multiple owners, single policy per owner. Doesn't account for actual ownership percentage.

Term policy that expired or was converted incorrectly. Term life insurance has a specific duration. If the owner outlives the term without conversion to permanent coverage, the buy-sell funding disappears.

Insurance amounts not indexed. Fixed-amount policies don't grow with business value. Even a 30-year term policy doesn't cover growth.

The discipline: review insurance amounts at least every 3-5 years. Update for business growth. Consider periodic valuation refreshes that adjust policy amounts.

Many buy-sell agreements reference "book value" or use formulas for determining buy-out price. These produce predictable results but often don't reflect current fair market value.

Fixed-price buy-sells: Agreement specifies a fixed dollar amount updated periodically. Easy to administer; requires regular updates to stay accurate.

Formula-based buy-sells: Price determined by formula (typically a multiple of earnings or book value). Predictable but may produce values significantly different from fair market.

Appraisal-based buy-sells: Price determined by professional appraisal at the time of trigger. Accurate to current value but expensive and contentious.

Hybrid: Combination approaches (fixed price with periodic updates, formula as default with right to request appraisal, etc.).

For insurance funding to work, the insurance amount needs to track the buy-sell valuation. If the buy-sell uses a formula that produces significantly different values over time, the insurance amount needs to be reviewed and updated in parallel.

In addition to death, buy-sell agreements often trigger on permanent disability. Disability buyouts are harder to fund because:

• Disability insurance pays over time (not lump sum), making lump-sum buyouts harder
• Definitions of "permanent disability" require clear specification
• The disabled owner may recover, creating return-to-work questions
• Purchase over time via installment creates ongoing cash flow needs

Specialized "disability buyout" insurance policies exist specifically to fund partnership buyouts triggered by permanent disability. These are distinct from individual disability income insurance (covered in 6.1) — they pay a lump sum to fund buyout rather than ongoing income replacement.

For buy-sell agreements funded through insurance, consider disability buyout coverage alongside life insurance to address the permanent disability scenario.

For most two-owner businesses with long-term holding intent and significant potential appreciation, cross-purchase is typically the better choice. The basis step-up advantage is concrete and meaningful.

For businesses with 3+ owners, the administrative complexity of cross-purchase typically tips the decision toward entity purchase, with the basis disadvantage accepted as the cost of simpler administration.

For businesses where partners have very different ages or health profiles, structural accommodations (adjusted premium funding, adjusted purchase prices) can mitigate the cross-purchase disparity issues. If adjustments can't be made cleanly, entity purchase may be easier.

For businesses with existing Section 754 elections or partnership structure, the entity-purchase basis disadvantage may be partially or fully mitigated, making entity purchase more competitive.

For businesses where owners expect to hold until their own deaths, the basis-at-later-death step-up eliminates the cross-purchase advantage, and simpler entity purchase wins.

The specific choice is often made in conjunction with an estate planning attorney and a CPA. The buy-sell structure interacts with other planning elements (owners' personal estate plans, their individual life insurance, their business valuation targets). Generic advice doesn't substitute for case-specific analysis.

What's universal: a buy-sell agreement without funded insurance is often a failure waiting to happen. Owners who put buy-sell agreements in place without funding mechanisms often find at the triggering event that the agreement can't be carried out. Funded coverage at adequate amounts — regardless of which structure — is the actual protection.