A buy-sell agreement is a contract between co-owners of a business that outlines what happens upon specified events. Not having one can lead to unforeseen, often significant consequences after a major event, such as when a co-owner dies, leaves the business, or retires.
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What is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract between the co-owners of a business that specifies what happens to an owner’s share upon a triggering event. Think of it as a business prenuptial agreement—one you hope you’ll never need, but that protects everyone involved if things go sideways.
In plain terms, the buy-sell agreement answers three critical questions: Who can buy the departing owner’s interest? At what price? And under what conditions? Without answers baked into a binding document, a co-owner’s death, disability, or departure can throw an otherwise healthy company into chaos.
Buy-sell agreements are used across all business structures: partnerships, LLCs, S corps, C corps, and corporations of every size.
Whether you’re a two-person partnership or a group of shareholders in a mid-size firm, a well-drafted buy-sell agreement is the legal backbone of your business succession plan. Without one, your business and your family may be left without a road map when it matters most.
The Triggering Events That Activate a Buy-Sell Agreement
A buy-sell agreement doesn’t take effect on its own; it requires a triggering event. These are specific circumstances that trigger or permit a buyout covered by most agreements.
Death
When a co-owner dies, their interest passes to their estate and, ultimately, to their heirs. Without a buy-sell agreement, those heirs—who may lack business experience—can become your new business partners overnight. The agreement gives the surviving owners the right or obligation to purchase the deceased owner’s share at a predetermined or formula-based price.
Disability
A disabled owner may still be legally entitled to a share of business income but may no longer be able to contribute to operations. A buy-sell agreement can include provisions allowing the other owners to buy out a co-owner who becomes permanently disabled, typically after a waiting period specified in the contract.
Divorce
If a co-owner divorces, their business interest may be divided as a marital asset. Which means a judge or a spouse’s attorney could end up with a claim on your company. A well-crafted buy-sell agreement prevents this by giving co-owners the right to purchase the interest before it transfers to an ex-spouse.
Retirement
The buy-sell agreement can specify the amount of notice a retiring owner must give, how their interest will be valued, and whether the buyout will be structured as a lump sum or as installment payments.
Voluntary Exit
Sometimes a co-owner simply wants to leave. A buy-sell agreement sets out the process, including restrictions on who can buy the departing owner’s interest, the valuation method, and the required pace of the transition.
Many agreements also address triggering events such as bankruptcy, criminal conviction, or an attempted sale to an outside party without first offering it to existing owners (a right of first refusal).
The Two Main Types of Buy-Sell Agreements
There are two primary types of buy-sell agreements, and the right structure depends on the number of owners, the business entity type, and each party’s tax situation.
Cross-Purchase Agreement
In a cross-purchase agreement, the surviving owners agree to purchase the departing owner’s interest.
Each co-owner typically holds a life insurance policy on the other owners, with the death benefit funding the purchase. This structure works well for businesses with two or three partners and offers a tax advantage: the purchasing owners receive a stepped-up cost basis in the shares they acquire, which can reduce capital gains taxes on a future sale.
The drawback is potential administrative complexity. With five partners, each would need policies on the other four—twenty policies in total—requiring ongoing management to keep premiums current and coverage aligned with the business valuation.
Entity Purchase (Stock Redemption) Agreement
In an entity purchase—also called a stock redemption agreement—the business itself buys the departing owner’s interest. The company holds the life insurance policies and uses the proceeds to fund the buyout. This approach is simpler to administer, regardless of the number of shareholders or partners.
The tradeoff: the surviving owners don’t receive the same stepped-up cost basis they’d get under a cross-purchase arrangement, so they may face higher capital gains taxes on a future sale.
There’s also a newer wrinkle to be aware of. In 2024, the U.S. Supreme Court ruled in Connelly v. United States that when a company owns life insurance to redeem a deceased owner’s shares, those insurance proceeds count as a company asset that increases the business’s value for estate tax purposes—and the obligation to buy out the shares doesn’t cancel that out.
In plain terms, a redemption structure can inflate the value of the deceased owner’s estate and the estate tax that comes with it. The ruling applies to corporations, partnerships, and LLCs alike, which is why many businesses with older entity-purchase agreements are revisiting them.
For S corps and LLCs, the tax treatment differs, another reason to involve a qualified CPA and attorney from the start.
Hybrid and “Wait-and-See” Agreements
A hybrid agreement gives the company the first right of purchase of the departing owner’s interest; if the company declines, the remaining owners can buy it themselves. This preserves flexibility, allowing the parties to choose the most tax-efficient structure when the triggering event occurs, rather than locking in a decision years in advance.
Funding the Agreement: Life Insurance and Disability Insurance
A buy-sell agreement is only as good as the funding behind it. This is where insurance plays a central role.
Life Insurance as the Funding Vehicle
Life insurance is the most common way to fund a buy-sell agreement for the triggering event of death. Each owner is insured for an amount equal to their ownership interest, and the death benefit provides the liquidity needed to complete the buyout.
Premium payments are predictable, and the death benefit is generally received income-tax-free. It’s critical to review your coverage regularly. A policy sized for a $1 million business is severely underfunded if the company is now worth $4 million.
Disability Insurance for Living Buyouts
Life insurance only covers the death of a business owner. Disability buyout insurance funds the purchase of a co-owner’s interest if they are unable to work due to a disability, typically paying a lump sum or a series of payments after a 12- to 24-month waiting period.
Without it, the remaining owners may be forced to draw on operating funds, take on debt, or negotiate an installment purchase—none of which are ideal when the business is already under strain.
Think of life and disability insurance as the financial muscle behind your buy-sell agreement. The contract tells you what to do; the insurance provides the funds to carry it out.
How to Value the Business
The buy-sell agreement must specify how the business will be valued upon a triggering event. There are four common approaches:
Fixed Price
The owners agree on a specific dollar value at the time of drafting and update it periodically, typically annually. Simple and predictable, but if owners forget to update it, the figure could quickly fall out of step with reality.
Formula-Based Valuation
A formula ties valuation to a financial metric—for example, three times average annual revenue over the prior three years or a multiple of EBITDA. This provides an automatic, objective calculation without requiring annual updates, but the formula must be chosen carefully for the specific industry and business model.
Book Value
Book value (assets minus liabilities as shown on the balance sheet) is easy to calculate, but it typically understates the true value of a thriving business by ignoring goodwill, customer relationships, and earning power. It’s generally a poor measure for most operating businesses.
Fair Market Value (Independent Appraisal)
A qualified independent appraiser determines the business’s value upon the occurrence of a triggering event. This method yields the most accurate and defensible result, but can be expensive and time-consuming.
Some agreements use a two-appraiser approach, with a third brought in as a tiebreaker if needed. Whichever method you choose, the IRS has historically scrutinized buy-sell agreements in which valuation appears designed to reduce estate tax liability rather than reflect genuine fair market value.
What Happens Without a Buy-Sell Agreement
Business owners who skip this critical planning step often learn its importance the hard way.
Without a buy-sell agreement, a triggering event can set off a cascade of costly consequences:
- A deceased owner’s heirs become co-owners by default, potentially forcing you into a partnership with someone who has no business experience, different goals, or an adversarial relationship with the remaining team.
- A divorcing owner may be compelled to transfer part of their interest to an ex-spouse, giving that ex-spouse an ownership stake in your company.
- Disagreements over the business’s value can escalate into costly litigation, draining time, money, and goodwill that the business can’t afford to lose.
- Business continuity suffers while ownership is in dispute — clients leave, key employees resign, and lenders may call loans.
- Without an agreed valuation, the IRS may challenge your estate’s business value, potentially triggering a larger estate tax liability than expected.
The cost of not having a buy-sell agreement can far exceed the relatively modest investment required to draft one properly.
Working With the Right Advisors
A buy-sell agreement sits at the intersection of business law, taxation, insurance, and financial planning. Your attorney drafts and reviews the legal language. Your CPA advises on the tax implications of the structure—particularly the cross-purchase vs. entity purchase decision and the tax treatment of insurance premiums and proceeds.
Your financial advisor coordinates the overall picture, ensuring that insurance funding is adequate, aligned with the current valuation, and integrated with your broader succession and estate planning strategy.
The right time to create a buy-sell agreement is before you need one. Once a triggering event is in motion, it’s too late to put protections in place.
If you already have a buy-sell agreement, review it regularly. Business values change, ownership interests shift, and tax law evolves. An agreement drafted five years ago may be outdated, underfunded, or no longer structured in the most tax-efficient manner.
Take the Next Step
A buy-sell agreement is one of the most powerful tools for protecting your business, your co-owners, and your family from the financial fallout of an unexpected event. It is a cornerstone of any serious business succession plan and an essential exit strategy for every business owner—regardless of company size or age.
At ARQ Wealth, we help business owners build comprehensive financial strategies that include buy-sell planning, business succession, and estate planning tailored to their needs. We invite you to reach out to an ARQ fiduciary advisor to start the conversation. It may be one of the most valuable investments you make in your business’s future.
Call us today to discuss whether a buy-sell agreement is right for you.