Buy-Sell Agreements: Protecting Business Continuity and Setting the Tax Value
A buy-sell agreement is a legally binding contract that controls the transfer of business ownership when a triggering event occurs: death, disability, retirement, divorce, bankruptcy, or voluntary departure of an owner. Without a buy-sell agreement, a deceased owner’s business interest passes to their estate, potentially leaving the surviving owners in partnership with the deceased owner’s heirs, spouse, or creditors. The agreement sets the price, the payment terms, and the funding mechanism (typically life insurance or installment payments).
Buy-sell agreement types and tax consequences:
Cross-purchase agreement:
- Surviving owners buy the departing owner’s interest directly
- Funded by life insurance owned by each co-owner on the other co-owners’ lives
- Tax benefit: surviving owners get a stepped-up basis in the purchased interest
- Complexity increases with more owners (n owners require n x (n-1) policies)
- Best for: 2-3 owner businesses
Entity redemption (stock redemption for C/S-Corps):
- The business buys back the departing owner’s interest
- Funded by life insurance owned by the business
- Tax consequence: surviving owners do NOT get a basis step-up (the business used its assets to buy out the departed owner, and the remaining owners’ basis does not change)
- Simpler for multiple owners (only n policies needed)
- Best for: businesses with many owners, or where simplicity is preferred
Hybrid (wait-and-see):
- Gives the entity the first right to purchase, with remaining owners having the right to purchase any interest the entity does not acquire
- Provides flexibility to optimize the tax result at the time of the event
- Most common structure recommended by advisors
Valuation methods:
- Fixed price: Set a specific dollar value, updated annually. Simple but often becomes stale.
- Formula: Revenue multiple, earnings multiple, or book value. Self-updating but may not reflect true market value.
- Appraisal: Independent valuation at the time of the event. Most accurate but adds cost and delay.
- IRS scrutiny (IRC 2703): The IRS may disregard the buy-sell price for estate tax purposes if: the agreement was not entered into at arm’s length, the terms are not comparable to similar arrangements, and the agreement is a device to transfer the interest for less than full value.
How does life insurance fund the buyout?
What are the tax differences between a cross-purchase and entity redemption buy-sell agreement?
In a cross-purchase agreement, the remaining owners buy the departing owner’s interest directly, and each buyer gets a stepped-up basis in the purchased interest equal to what they paid. In an entity redemption, the business itself buys back the departing owner’s interest, which means the remaining owners don’t get a basis step-up (their percentage ownership increases but their basis stays the same). Cross-purchase agreements funded with life insurance can become unwieldy when there are many owners (each owner needs a separate policy on every other owner). Entity redemptions are simpler administratively but can trigger the accumulated earnings tax if the corporation retains excess funds for the anticipated buyout. For S-Corps, redemptions that don’t completely terminate a shareholder’s interest are treated as distributions (potentially taxable as dividends from accumulated E&P), not as sales, which can produce unfavorable tax results.
Related guides:
- Buy-Sell Agreements: Tax Planning for Business Ownership Transitions
- Family Business Succession: Tax-Efficient Methods for Transferring a Business to the Next Generation
- Law Firm Succession Planning: Buy-Sell Agreements, Practice Valuation, and Partner Transitions
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Yarik Yarosh, CPA. "Buy-Sell Agreements: Protecting Business Continuity and Setting the Tax Value." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-business-succession-buy-sell-agreement
This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.