Buy-Sell Agreements and How They're Funded (After Connelly)

What a buy-sell does

A buy-sell agreement is a binding contract among a business’s owners, or between the owners and the business entity, that governs the transfer of an ownership interest. It answers three questions in advance: who may (or must) buy a departing owner’s interest, at what price or formula, and how the purchase is funded. Without one, the death or departure of an owner can leave the survivors in business with an heir they never chose, or force a distress sale — and can leave the departing owner’s family holding an interest no one will buy.

The triggering events

A well-drafted agreement spells out which events trigger a buy-out — typically death, disability, retirement, voluntary departure, divorce, bankruptcy, or loss of a professional license — and whether the buy-out is mandatory or an option for each side. Death is the event most tied to estate planning, because it is when the interest lands in an estate, must be valued for estate tax, and needs to be converted to cash for the family.

Cross-purchase vs. redemption

There are two basic architectures, and the difference is who does the buying:

• Cross-purchase. The surviving owners buy the departing owner’s interest directly. When funded with life insurance, each owner typically owns a policy on each of the others.
• Entity-purchase (redemption). The business itself buys back — redeems — the departing owner’s interest. When funded with insurance, the company owns the policies on its owners.

Redemption is administratively simpler, especially with many owners (one set of company-owned policies instead of a web of cross-owned ones). That simplicity is exactly what the Supreme Court’s 2024 decision complicated.

What Connelly changed

In Connelly v. United States, 602 U.S. ___ (2024), the Supreme Court unanimously held two things about a redemption funded with corporate-owned life insurance. First, the life-insurance proceeds the corporation receives to buy back a deceased owner’s shares are a corporate asset that increases the company’s value for estate-tax purposes. Second, the corporation’s obligation to redeem those shares does not offset that increase (Connelly v. United States, No. 23-146 (June 6, 2024)).

The decision has not banned redemptions, but it has sent owners and their advisers back to the drawing board. Common responses include using a cross-purchase structure (where the insurance is owned by the individual buyers, not the company, and so does not inflate the company’s value), or holding the policies in a separate insurance LLC or similar entity. Which fits depends on the number of owners, their ages, and the mechanics — a review worth doing with counsel if your buy-sell is a corporate redemption funded by company-owned insurance.

Fixing the price for estate tax: §2703

A buy-sell can also set the value of the interest for estate-tax purposes — but only if it clears the requirements of IRC § 2703. The agreed price is respected only if the arrangement (1) is a bona fide business arrangement, (2) is not a device to transfer the interest to family members for less than full value, and (3) has terms comparable to what unrelated parties would agree to at arm’s length. Long-standing case law adds that the price must be binding both during life and at death and fixed or determinable by a clear formula. Fail these, and the IRS can ignore the buy-sell price and tax the estate on a higher fair market value — which is why the price mechanism, and regular updates to it, matter as much as the funding.

Sources & methodology