A buy-sell agreement is one of the most important planning documents a closely held business owner can have. It is, at its core, a contract among co-owners of a business — or between the owners and the entity itself — that governs what happens to an owner’s interest when a triggering event occurs. Triggering events typically include death, permanent disability, retirement, termination of employment, divorce, bankruptcy, and an owner’s attempted involuntary transfer of the business interest. The buy-sell agreement addresses two fundamental questions: who may own an interest in the business, and at what price. Its dual purpose is to ensure business continuity by preventing ownership from passing to unwanted parties, and to provide liquidity to departing owners (or their estates) at a predetermined or determinable price.

For estate planning purposes, the price at which a business interest is valued under a buy-sell agreement has historically been relevant to the estate tax value of that interest at the owner’s death. If the agreement obligated the decedent’s estate to sell the interest at a fixed price, the argument was that the estate tax value could not exceed that price. The IRS has long challenged this argument, and the rules of Section 2703 of the Internal Revenue Code now govern the circumstances under which a buy-sell agreement will be respected for estate and gift tax valuation purposes. Getting these rules right is more important than ever following the Supreme Court’s 2024 decision in Connelly v. United States, which dramatically changed the calculus for life-insurance-funded entity redemption agreements.

The Two Main Structures: Entity Redemption vs. Cross-Purchase

Buy-sell agreements are structured in one of two basic forms, or a hybrid of the two. In an entity redemption agreement, the entity itself — the corporation, LLC, or partnership — is obligated to purchase the departing owner’s interest upon the occurrence of a triggering event. The entity uses its own assets, insurance proceeds, or other funding sources to buy back the interest, which is then retired. The remaining owners do not personally purchase the departing owner’s interest; rather, their proportional ownership of the entity simply increases as a result of the redemption.

In a cross-purchase agreement, the remaining owners are personally obligated to purchase the departing owner’s interest. Each owner agrees to buy a proportional share of the departing owner’s interest directly from that owner (or, in the case of death, from that owner’s estate). Cross-purchase agreements require each owner to hold sufficient resources to fund their purchase obligation, which is typically accomplished through life insurance policies that each owner holds on the lives of the other owners.

The income tax consequences of the two structures differ in an important way with respect to the surviving owners’ tax basis. In a cross-purchase, the surviving owners purchase the decedent’s interest directly, paying for it with insurance proceeds or other funds. Their tax basis in the acquired interest equals the purchase price, which is typically at or near the fair market value of the interest at the time of purchase. In an entity redemption, the surviving owners do not personally acquire the decedent’s interest — the entity does — and the surviving owners generally do not receive any step-up in the basis of their remaining interests as a result of the redemption. Over time, this difference in tax basis has significant implications for the gain that the surviving owners will recognize when they eventually sell their interests.

The Estate Tax Valuation Problem and the History of Buy-Sell Agreements

Historically, buy-sell agreements were used by closely held business owners not only for business succession purposes but also as a mechanism for reducing the estate tax value of the business interest at death. If a buy-sell agreement fixed the purchase price at a value established years earlier — often at a discount to what the business would be worth in an arm’s length sale — the estate could argue that the fair market value of the interest was limited to the contractual price. The IRS recognized this use of buy-sell agreements as a potential abuse and challenged it in numerous cases.

The Tax Reform Act of 1990 added Section 2703 to the Internal Revenue Code in response to these concerns. Section 2703 provides that the value of property for gift and estate tax purposes is determined without regard to any right or restriction relating to the property — including rights and restrictions in a buy-sell agreement — unless the agreement satisfies all three of the following requirements. First, the arrangement must be a bona fide business arrangement. Second, it must not be a device to transfer the property to members of the decedent’s family for less than full and adequate consideration. Third, its terms must be comparable to similar arrangements entered into by persons dealing at arm’s length.

Section 2703: The Three Requirements in Practice

The bona fide business arrangement requirement asks whether the buy-sell agreement serves a legitimate business purpose independent of its estate tax consequences. Courts and the IRS look for evidence that the restrictions in the agreement are commercially reasonable — for example, a right of first refusal that gives co-owners the opportunity to buy out a departing owner before that owner can sell to a stranger is a classic business arrangement that protects the closely held nature of the enterprise. An agreement that does nothing but set a low fixed price for estate tax purposes, without any genuine restriction on transferability or any other business function, is unlikely to satisfy this requirement.

The not-a-device requirement focuses on whether the agreement is designed primarily to shift value to family members at below-market prices rather than to serve a genuine business function. Treasury Regulation Section 20.2703-1(b)(1) provides that an agreement will be treated as a device if it is with or for the benefit of family members. However, the regulation also provides a safe harbor: an agreement is not a device if it satisfies the bona fide business arrangement requirement and its terms are comparable to arm’s length terms. The family-only buy-sell agreement — one that covers only transfers among family members and has no participation from unrelated co-owners — is particularly vulnerable to challenge under the device test.

The comparable arm’s length terms requirement is often the most difficult to satisfy in practice. It requires that the pricing formula, the triggering events, and the other material terms of the agreement be similar to arrangements that unrelated parties would negotiate with each other. This does not mean the agreement must be identical to a market precedent; rather, the standard is whether a comparable arrangement could be found in the marketplace. Treasury Regulation Section 20.2703-1(b)(4) states that this comparison is made with reference to facts and circumstances at the time of the agreement’s execution, not at the time of the transfer. Practically, business owners should obtain an independent appraisal or market study at the time of drafting to document that the valuation formula reflects current market practice.

When all three requirements are met, the buy-sell agreement price is respected for estate and gift tax purposes, and the estate tax value of the interest is determined by reference to the contractual price rather than an independent appraisal of fair market value. This can result in significant estate tax savings if the business has appreciated substantially since the price was set. When the requirements are not met, the buy-sell agreement is disregarded for estate tax purposes and the interest is valued at its true fair market value, regardless of what the agreement says.

Connelly v. United States: The Supreme Court’s 2024 Decision

In June 2024, the Supreme Court of the United States decided Connelly v. United States, a case that has fundamentally altered the planning landscape for entity redemption buy-sell agreements funded with life insurance. The case arose from the estate of Michael Connelly, who owned a majority interest in a closely held corporation. The corporation held life insurance policies on Connelly’s life and was obligated under a buy-sell agreement to redeem his shares upon his death using the insurance proceeds. The question before the Court was how the insurance proceeds and the redemption obligation should affect the estate tax value of the corporation and, by extension, the value of Connelly’s shares.

The estate argued that the corporation’s obligation to redeem the shares was a liability that offset the insurance proceeds for purposes of valuing the corporation. Under the estate’s theory, the insurance proceeds added to the corporation’s value, but the corresponding redemption obligation subtracted from it, leaving the corporation’s value roughly unchanged. The IRS argued that the insurance proceeds were a corporate asset that increased the corporation’s value, and that the redemption obligation was not an offsetting liability because it was not a true debt — it was simply a contractual commitment to pay shareholders for their own stock.

The Supreme Court agreed with the IRS, holding unanimously that a contractual obligation to redeem a shareholder’s stock is not a liability that reduces the corporation’s fair market value for estate tax purposes. The Court reasoned that a redemption obligation does not reduce the net worth of the corporation in the same way that a debt to a third party does — because the money paid in the redemption simply transfers from the corporation to the estate of the selling shareholder, and the shares are then extinguished. The remaining shareholders are no better or worse off; the corporation simply has fewer shares outstanding. As a result, the full amount of the life insurance proceeds is included in the corporation’s value, which in turn increases the estate tax value of the decedent’s shares.

The practical consequence of Connelly is striking. Under the pre-Connelly understanding, many practitioners had structured entity redemption plans funded with life insurance on the assumption that the insurance proceeds would be offset by the redemption obligation, leaving the business value roughly neutral. Post-Connelly, this assumption is wrong: the insurance proceeds increase the corporation’s value, which increases the estate tax on the decedent’s shares. In effect, the life insurance that was intended to fund the buyout also creates an additional estate tax burden. This is particularly severe in the context of closely held corporations where the decedent’s estate must pay estate tax on the inflated corporate value but may not have the cash to do so unless it forces a sale of the business.

How Connelly Affects Planning: The Shift Toward Cross-Purchase

In the aftermath of Connelly, many practitioners are recommending that closely held business owners with entity redemption structures funded by life insurance consider converting to cross-purchase arrangements. In a cross-purchase, the surviving owners — not the corporation — own the life insurance policies and use the proceeds to purchase the decedent’s shares. Because the corporation does not own the insurance policies, there are no insurance proceeds to inflate the corporation’s value for estate tax purposes. The Connelly problem does not arise in a cross-purchase structure.

The cross-purchase structure does have its own complications. In a business with many co-owners, the number of life insurance policies required under a cross-purchase can become unwieldy — in a five-owner business, each owner must hold policies on each of the other four owners, resulting in twenty policies in total. This is a significant administrative burden, and the premiums for each policy are paid from the individual owners’ personal funds (not deductible at the corporate level). As business ownership changes through the admission of new owners, the policy structure must be updated.

Existing entity redemption agreements funded with life insurance should be reviewed in light of Connelly and assessed for conversion. The decision to convert from entity redemption to cross-purchase involves income tax considerations (particularly the potential recognition of gain if policies are transferred out of the corporation) as well as the administrative complexity noted above. Counsel experienced in both buy-sell planning and insurance taxation should be engaged before any restructuring is undertaken.

Trusteed Cross-Purchase Arrangements

One solution to the administrative complexity of cross-purchase agreements in multi-owner businesses is the trusteed cross-purchase arrangement. In a trusteed cross-purchase, a trustee — typically a bank trust department or other independent fiduciary — holds all of the life insurance policies on behalf of the owners, administers the premium payments, and coordinates the purchase at death. Each owner has a beneficial interest in the policies on the lives of the other owners, but the trustee handles the mechanics.

The insurance trust in a trusteed cross-purchase is distinct from an ILIT used in estate planning. The trustee’s role is primarily administrative — to collect premiums, maintain the policies, and distribute the proceeds to the appropriate purchasing owners upon a triggering event. The owners retain ownership of their respective interests in the policies, and the death benefit proceeds flow through the trustee to the purchasing owners, who then purchase the decedent’s interest from the estate.

A trusteed cross-purchase arrangement simplifies administration significantly in multi-owner businesses, avoids the proliferation of individual policies, and ensures that the purchase mechanics are handled consistently when a triggering event occurs. After Connelly, it is also a way to preserve the estate tax advantages of the cross-purchase structure without the burden of individual ownership of multiple policies.

Life Insurance Funding: Ownership Structure and Post-Connelly Analysis

Life insurance is the most common funding mechanism for buy-sell agreements at death because it provides a guaranteed source of liquidity at precisely the time it is needed. The amount of insurance is typically set to equal the agreed-upon purchase price for the business interest, so that when the triggering event occurs, the beneficiary of the policy has the cash available to complete the purchase without disrupting the business’s operations or forcing a sale of assets.

The ownership structure of the life insurance policies is critical both before and after Connelly. Under an entity redemption structure, the corporation or LLC owns the policies, pays the premiums, and is the beneficiary. The premiums are not deductible by the entity (under Section 264(a)(1)), but the death benefit is received income-tax-free under Section 101(a). Post-Connelly, this structure creates an estate tax problem because the insurance proceeds inflate the value of the entity and, correspondingly, the taxable value of the decedent’s interest.

Under a cross-purchase structure, each owner individually owns policies on the other owners, pays the premiums personally, and receives the death benefit income-tax-free. The policies are personal assets of the owners and do not appear on the entity’s balance sheet. As a result, there are no insurance proceeds to inflate the entity’s estate tax value. The surviving owners use the death benefit to purchase the decedent’s interest from the estate, and their tax basis in the acquired interest is stepped up to the purchase price.

LLC and Partnership Buy-Sell Provisions

Buy-sell agreements in the context of LLCs and partnerships are governed by the same fundamental principles as corporate buy-sell agreements, but the tax rules differ in important ways. In a partnership or LLC taxed as a partnership, a redemption of a partner’s or member’s interest is treated as a liquidating distribution rather than a sale, which can have different income tax consequences for both the departing partner and the remaining partners. The application of Section 736, which distinguishes between payments for the partner’s share of partnership property and payments for goodwill or unrealized receivables, is particularly important in service partnerships and professional firms.

The Connelly decision was decided in the corporate context, and its holding technically applies to corporations. However, the underlying principle — that life insurance proceeds held by an entity to fund a redemption are an asset of the entity that increases its value for transfer tax purposes — may have broader application to LLCs and partnerships as well, at least in circumstances where the entity-owned insurance is an asset that a hypothetical buyer would take into account in determining the entity’s value. Counsel should assess the Connelly implications for entity-redemption structures in the LLC and partnership context on a case-by-case basis.

Practical Guidance: Auditing and Restructuring Buy-Sell Agreements

Every closely held business owner with an existing buy-sell agreement should review that agreement in light of both Connelly and the Section 2703 requirements. The review should address several specific questions. Does the agreement use a fixed price or a formula to determine the purchase price, and was that price or formula validated against market comparables at the time of drafting? Have the Section 2703 requirements been documented, including evidence of a bona fide business purpose and comparability to arm’s length arrangements? If the agreement uses a fixed price that has not been updated since the business was worth much less, is that price still defensible as an arm’s length value?

If the business uses an entity redemption structure funded with life insurance, the owner should work with counsel to assess the estate tax impact of the Connelly holding. The key question is whether the life insurance proceeds would be included in the entity’s value at the time of the owner’s death and, if so, by how much the resulting estate tax burden would exceed what the owner had anticipated. If the excess is material, restructuring to a cross-purchase — or a trusteed cross-purchase for multi-owner businesses — should be seriously considered.

Converting from an entity redemption to a cross-purchase is not a trivial exercise. The corporation or LLC must transfer the insurance policies to the individual owners (or to the insurance trustee), which may trigger gain if the policies have cash value and the transfer does not qualify for an exception to the transfer-for-value rule under Section 101(a)(2). The transfer-for-value rule provides that life insurance proceeds received by a beneficiary who acquired the policy in exchange for valuable consideration are not fully excluded from income. Specific exceptions apply — including transfers to the insured, to a partner of the insured, or to a partnership in which the insured is a partner — but these exceptions must be carefully analyzed before any policy is transferred.

Buy-sell planning should be integrated with the overall estate plan. The valuation established in the buy-sell agreement, and the liquidity provided by life insurance, should be considered in the context of the owner’s total estate, the anticipated estate tax burden, and the availability of other assets to fund estate taxes and family needs. An estate plan that relies on a buy-sell agreement to establish a low value for the business interest must satisfy Section 2703, or the IRS will disregard the agreement and value the business at its true fair market value — potentially resulting in a much larger estate tax bill than anticipated, and without the liquidity to pay it. Regular reviews of the buy-sell agreement, the insurance coverages, and the business valuation, conducted in coordination with the estate planning attorney, business counsel, and insurance advisor, are essential to keeping this critical planning document effective.

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