WEST VIRGINIA (LOOTPRESS) – Small business owners spend an enormous amount of time worrying about problems that might happen next week. Will we make payroll, is the customer going to pay, do we need another employee, can we afford the new equipment, and why did the air conditioner quit working in July? There is another question that is considerably less pleasant, but for many business owners it is considerably more important: what happens if one of the owners dies?
For many closely held businesses, the answer is surprisingly unclear. Two friends may have spent twenty years building a successful company together, two brothers may own a construction company, three physicians may own a medical practice, or a husband and wife may have created a business that represents most of their family’s net worth. Everybody knows how the business operates on Monday morning, but far fewer people have seriously considered what happens on Tuesday morning if one of the owners dies Monday night.
A properly designed buy/sell agreement can answer that question, and life insurance can provide the money necessary to make the answer actually work.
Death Does Not Make Ownership Disappear
Imagine that John and Mike each own 50 percent of a successful business. They have worked together for twenty years, the company is worth $4 million, and each man’s interest is worth approximately $2 million for purposes of our simplified example. Then Mike unexpectedly dies.
Mike’s ownership interest does not disappear when he dies. Depending upon how the business is structured and how Mike’s estate plan is written, his interest may now belong to his estate, his wife, his children, a trust, or some combination of beneficiaries. John suddenly has a new business problem because yesterday his partner was Mike, while today his partner may effectively be Mike’s widow.
She may be a wonderful person, but she may also know absolutely nothing about operating the company. She has a problem of her own because her husband owned a $2 million business interest, but a $2 million interest in a closely held company does not necessarily put $2 million in the bank. She may need cash, John wants control of the business, and Mike’s family wants the value of Mike’s ownership interest. That is exactly the problem a buy/sell agreement is intended to solve.
The Agreement Determines What Happens
A buy/sell agreement is essentially a contract among the business owners, and sometimes the business itself, establishing what happens to an owner’s interest when certain events occur. Death is the obvious event, but a good agreement may also address disability, retirement, divorce, bankruptcy, termination of employment, voluntary sale, and other circumstances that could affect ownership.
The agreement can establish who has the right or obligation to purchase the departing owner’s interest, but it also needs to establish how the purchase price will be determined. Saying that John gets Mike’s stock if Mike dies is not enough because the next question is obvious: for how much? A business that was worth $500,000 when two people started it fifteen years ago might be worth $5 million today.
There are several ways to address valuation. The owners might periodically agree upon a value, require an appraisal, use a formula based upon earnings, or employ another method appropriate for the particular business. There is no universal valuation formula that works for every closely held company, but there needs to be a mechanism that produces a reasonable answer when the question eventually matters.
Determining the price, however, is only half of the problem. Someone still needs the money.
A $2 Million Promise Is Not the Same as $2 Million
Return to John and Mike. Their agreement says that when either man dies, the deceased owner’s $2 million interest will be purchased. That sounds like good planning until someone asks where the $2 million is going to come from.
A business may have substantial value without having substantial cash. A company could own buildings, equipment, vehicles, inventory, intellectual property and accounts receivable while keeping relatively little cash sitting in the bank. John may personally be wealthy on paper because he owns half of the company, but that does not mean he has $2 million available to purchase Mike’s half.
The company could borrow the money, it could sell assets, John could attempt to finance the purchase personally, or Mike’s family could accept payments over ten or fifteen years and hope the company remains successful enough to make them. None of those possibilities is particularly attractive at the exact moment the company has lost one of its owners, and some could place significant financial pressure on the business at the worst possible time.
This is where life insurance becomes useful. Life insurance can create liquidity at precisely the event that triggers the purchase, which allows the owners to plan for a large financial obligation before anyone knows when that obligation will occur.
Creating the Money When It Is Needed
If Mike dies, a life insurance policy on Mike produces a death benefit. Depending upon how the arrangement has been structured, those proceeds can then be used to purchase Mike’s business interest according to the terms of the buy/sell agreement.
Instead of John telling Mike’s widow that he owes her $2 million but does not have it, there is a source of cash specifically intended to fund the transaction. Mike’s family receives value for his ownership interest, John ends up owning the business, and the company does not necessarily have to liquidate equipment, real estate, or other productive assets to generate the purchase price.
The deceased owner’s family also avoids becoming an involuntary business partner with the surviving owner. Everyone knew the rules before the crisis occurred, and the money necessary to carry out those rules was put in place while everyone was alive and capable of planning together. That is exactly what good estate and business succession planning is supposed to accomplish.
Who Owns the Insurance?
This is where the planning becomes more sophisticated because there are several ways to structure an insured buy/sell arrangement. Two of the most common approaches are an entity redemption arrangement and a cross purchase arrangement, and although both can ultimately result in the surviving owner controlling the business, the legal and tax consequences can be quite different.
Under an entity redemption structure, the business generally owns life insurance on its owners. If Mike dies, the company receives the insurance proceeds and uses the money to redeem Mike’s ownership interest from his estate or beneficiaries. After the redemption, John’s interest represents all of the remaining outstanding ownership. Conceptually, it is simple because the company buys Mike out.
A cross purchase arrangement works differently. John might own a policy on Mike while Mike owns a policy on John. If Mike dies, John receives the insurance proceeds and personally uses them to purchase Mike’s interest from Mike’s estate or beneficiaries. From across the street the result may look almost identical, because Mike’s family has cash and John owns the business, but the tax consequences can be significantly different.
The Supreme Court Changed the Conversation
A 2024 United States Supreme Court decision, Connelly v. United States, made the distinction between these structures particularly important. The case involved two brothers who owned a closely held corporation, and the corporation owned life insurance intended to provide money to redeem the shares of a deceased brother.
When one brother died, the corporation received life insurance proceeds and used part of those proceeds to redeem his shares. The estate argued that the insurance increased the company’s assets, but that the company’s obligation to redeem the deceased shareholder’s stock should effectively offset that increase when valuing the company for federal estate tax purposes.
The Supreme Court disagreed. It held that the corporation’s contractual obligation to redeem the shares at fair market value was not necessarily a liability that reduced the company’s value for estate tax purposes, while the life insurance proceeds received by the corporation were an asset. The result was important because increasing the value of the corporation also increased the value of the deceased shareholder’s ownership interest for estate tax purposes.
Connelly did not make life insurance funded buy/sell agreements obsolete, and it did not establish that every entity redemption arrangement is a bad idea. What it did was give closely held business owners and their advisors another very good reason to carefully consider who owns the insurance, who receives the proceeds, and how the purchase will actually occur.
If a business has an old buy/sell agreement sitting in a corporate minute book that has not been seriously reviewed in fifteen years, Connelly provides a good reason to dust it off.
Why Cross Purchase Agreements Can Be Attractive
A cross purchase arrangement can avoid some of the valuation concerns that arise when a corporation receives insurance proceeds to redeem its own shares. It can also provide an important income tax basis advantage to the surviving owner.
Suppose John purchases Mike’s shares for $2 million. John’s basis in the shares he purchases will generally reflect the amount he paid for them, and that additional basis can become very important if John later sells the company. By contrast, when a corporation redeems another shareholder’s stock, the remaining shareholder generally does not receive the same direct increase in the basis of his own shares merely because the corporation made the redemption.
That does not mean cross purchase agreements are always superior. Imagine a company with six owners and consider the number of policies that might be required if every owner has to own insurance on every other owner. Differences in age and health can also create substantial differences in premium costs, while ownership changes can make administration increasingly complicated.
There are more sophisticated structures that can sometimes address those problems, including arrangements involving trusts or other entities. The important point is not that every business should use a cross purchase arrangement, but that the structure should be chosen intentionally after considering the legal, tax, insurance, and practical consequences.
Life Insurance Is Generally Income Tax Free, but the Rules Matter
Another reason life insurance works particularly well for buy/sell funding is its federal income tax treatment. Life insurance death benefits are generally excluded from the beneficiary’s gross income, which means the death benefit can potentially create a large pool of cash without simultaneously creating a large federal income tax bill.
The word “generally” matters because federal tax law contains exceptions and special rules. Transfers of existing policies for valuable consideration can create transfer for value issues, and employer owned life insurance is subject to its own requirements. A business therefore should not casually move old policies among owners and entities without first considering the tax consequences.
The ownership and beneficiary structure of the insurance needs to coordinate with the buy/sell agreement. The insurance policy and the legal agreement are not two unrelated pieces of planning, they are supposed to operate together when the triggering event occurs.
How Much Insurance Do You Need?
At first this sounds like a simple question. If Mike’s interest is worth $2 million, buy $2 million of insurance. That may be correct today, but the business is hopefully not going to remain worth the same amount forever.
Suppose John and Mike establish their plan when the company is worth $4 million. Ten years later, the business is worth $10 million, so Mike’s half is now worth $5 million while the policy still provides only $2 million. The owners now have a $5 million purchase obligation and only $2 million with which to fund it.
They did some planning, but they did not finish the job.
Buy/sell agreements and their funding need periodic review because businesses change. The business should be valued periodically, or the valuation formula contained in the agreement should at least be tested against reality, and insurance coverage should be compared with the expected purchase obligation. A plan established in 2016 may not adequately fund the same business in 2026.
Permanent Insurance or Term Insurance?
There is no universal answer to whether term or permanent life insurance should be used. Term insurance can provide a large death benefit at a relatively low initial premium, which can be particularly attractive for younger business owners who need substantial amounts of coverage.
The obvious problem is that successful businesses can last a long time. If two 40 year old owners expect to remain partners into their seventies, a twenty year term policy does not permanently solve the problem. The coverage may expire at precisely the age when obtaining replacement insurance becomes much more expensive or, because of changes in health, potentially impossible.
Permanent life insurance can provide coverage designed to remain in force for life, assuming the policy is properly funded and maintained. Depending upon the type of policy, it may also accumulate cash value that could become relevant if an owner retires, leaves the company, or the buy/sell arrangement changes before death occurs. That additional flexibility comes with a price because permanent insurance is generally considerably more expensive than term insurance.
The right choice depends upon the owners’ ages, health, cash flow, expected duration of the business relationship, and what events the agreement is intended to fund. The insurance product should solve the legal and economic problem, rather than designing the legal agreement merely to justify an insurance product somebody wanted to sell.
Disability May Be the Bigger Problem
Death is relatively easy to define, but disability can be considerably more complicated. Suppose Mike does not die, but instead suffers a serious medical event at age 52 and can never return to work. He still owns half the company, while John may now be doing nearly all of the work.
That arrangement can become contentious very quickly. Mike may understandably believe that he spent twenty years building the business and still owns half of it, while John may understandably wonder why he is working sixty hours a week to generate profits that are still being divided with someone who no longer works there.
A good buy/sell agreement should therefore consider disability as well as death. Disability buyout insurance may provide funding for that risk, although it operates differently from life insurance and can be more complicated and expensive. The broader lesson is that business succession planning should address the realistic ways an ownership relationship can end, and death is only one of them.
Your Business May Be Your Largest Asset
Many small business owners think about estate planning primarily in terms of their house, retirement accounts, investments, and life insurance. Then we look at the balance sheet and discover that the business is worth more than everything else combined.
That changes the conversation because a closely held business is not merely another asset on a financial statement. It may provide the owner’s income, employ family members, support dozens of employees, own valuable real estate, and represent thirty years of work. Leaving that asset without a succession plan can create problems for everyone involved.
The surviving owner needs control, the deceased owner’s family needs fair value, the employees need stability, and the business needs liquidity. A properly drafted and properly funded buy/sell agreement attempts to address all four of those concerns before the event that makes them urgent.
Dust Off the Agreement
If you own a closely held business with another person, there are two fairly simple questions worth asking. What happens to my ownership interest if I die tonight, and where does the money come from to carry out whatever our agreement says is supposed to happen?
If the first answer is buried somewhere in an agreement nobody has read since 2012 and the second answer is “we’ll figure it out,” there is work to do. Review the agreement, determine what the company is actually worth, make sure the valuation provisions still make sense, and review the insurance intended to fund the transaction. Look at who owns the policies, who pays the premiums, who receives the proceeds, and whether the amount of coverage bears any relationship to the current value of the ownership interests it is supposed to purchase.
For businesses using an entity redemption arrangement, the Supreme Court’s decision in Connelly provides another reason to review how the plan is structured and what the receipt of corporate owned life insurance may mean for valuation. An arrangement that made perfect sense when it was drafted years ago may deserve reconsideration under today’s law and today’s business value.
A buy/sell agreement determines what is supposed to happen, while life insurance can provide the money that allows it to happen. For owners of closely held businesses, putting those two pieces together can mean the difference between an orderly transition and leaving a surviving business owner and a grieving family to negotiate one of the largest financial transactions of their lives after the person who brought them together is already gone.
That is a problem worth solving while everyone is still sitting around the same table.
Brandon Steele, JD, CLU is an attorney in West Virginia and former financial advisor. A focus of his practice is estate and business planning. His firm, The Steele Firm, PLLC, is based in Beckley, WV.
This article is intended for general educational purposes only and does not constitute individual legal, tax, insurance, or investment advice. Buy/sell agreements and their funding should be designed around the ownership structure, tax circumstances, insurance needs, and objectives of the particular business and its owners.
