Buy-Sell Agreement Insurance: Cross-Purchase vs Entity Redemption and the Tax Difference at Exit
If your business has more than one owner and you do not have a funded buy-sell agreement, you have a problem that does not feel like a problem yet. It will feel like one the morning something happens to one of you.
A buy-sell agreement is a contract between co-owners that specifies what happens to each owner’s interest when a triggering event occurs: death, disability, retirement, voluntary departure, divorce, or deadlock. It defines who can buy, at what price, and how the purchase gets funded.
Without one, each triggering event becomes a negotiation under duress with attorneys on multiple sides, conflicting interests, and no predefined rules. With one, the event is handled by the agreement: the price is determined by the valuation mechanism, the funding is available through insurance, and the transition follows the process both parties agreed to when they were still thinking clearly.
A buy-sell agreement funded by life insurance is the most reliable mechanism for ensuring business ownership transitions happen cleanly when a partner dies, becomes disabled, or exits. The two primary structures, cross-purchase (owners buy each other’s shares) and entity redemption (the business buys the departing owner’s shares), produce meaningfully different tax outcomes at exit. Choosing the wrong structure can cost the remaining owners hundreds of thousands of dollars in additional capital gains taxes when the business is eventually sold.
Key Takeaways
- Every business with multiple owners needs a funded buy-sell agreement. The cost of implementing one is a fraction of the cost of not having one when a triggering event occurs.
- Cross-purchase agreements: each owner buys a life insurance policy on the other owners. When one dies, the surviving owners use the death benefit to purchase the deceased owner’s shares directly. The surviving owners’ tax basis in the shares is stepped up to the purchase price.
- Entity redemption agreements: the business buys life insurance on each owner. When one dies, the business uses the death benefit to redeem the deceased owner’s shares. The surviving owners’ tax basis does NOT step up, which creates a larger capital gains tax bill when the business is eventually sold.
- The tax basis difference between the two structures can represent 15-25% of the capital gains tax bill at the eventual sale. For a $10M exit, that can be $200K-$400K in additional taxes under the wrong structure.
- Both structures need to be reviewed every 2-3 years to ensure the valuation formula reflects the current value of the business and the insurance coverage is adequate.
Cross-Purchase: How It Works
In a cross-purchase arrangement, each owner purchases a life insurance policy on every other owner. In a two-person partnership, Owner A buys a policy on Owner B, and Owner B buys a policy on Owner A.
When Owner B dies, Owner A receives the death benefit (tax-free, since life insurance death benefits are generally income tax-free to the beneficiary). Owner A uses that money to purchase Owner B’s shares from Owner B’s estate, at the price determined by the buy-sell agreement’s valuation formula.
The critical tax benefit: Owner A’s tax basis in the shares they just purchased is the purchase price they paid. If Owner A later sells the business, their capital gains are calculated from this stepped-up basis. If they paid $2M for Owner B’s 50% stake and later sell the entire business for $12M, their capital gain on Owner B’s shares is $4M ($6M sale proceeds on that 50% minus $2M basis), not $6M.
The complication: the number of policies grows geometrically with the number of owners. Two owners need 2 policies. Three owners need 6. Four owners need 12. For businesses with more than 3-4 owners, this can become administratively burdensome.
Entity Redemption: How It Works
In an entity redemption arrangement, the business itself purchases a life insurance policy on each owner. When an owner dies, the business receives the death benefit and uses it to redeem (buy back) the deceased owner’s shares from the estate.
The advantage: simplicity. One policy per owner regardless of how many owners there are. The business owns, pays for, and manages all policies.
The tax disadvantage: when the business redeems the deceased owner’s shares, the surviving owners’ tax basis in their shares does not change. Their basis remains whatever they originally paid for their shares, even though they now own a larger percentage of the business. When the business is eventually sold, the surviving owners’ capital gains are calculated from their original (lower) basis, producing a larger tax bill.
The practical example: Owner A and Owner B each own 50% of a business they started for $100K total. Owner A’s basis is $50K. Owner B dies. The entity redeems Owner B’s shares for $2M. Owner A now owns 100% of the business, but their basis is still $50K. When Owner A sells the business for $10M, their capital gain is $9.95M ($10M minus $50K). If a cross-purchase structure had been used, Owner A’s basis would be $2.05M ($50K original + $2M purchase price), and their capital gain would be $7.95M. The tax difference at 23.8%: approximately $476K in additional federal taxes under entity redemption.
Which Structure Is Right for Your Business
For businesses with 2-3 owners where the eventual sale is likely within 10-15 years: cross-purchase is almost always the better tax structure. The basis step-up produces meaningful tax savings at the eventual exit, and the administrative burden of managing a small number of policies is manageable.
For businesses with 4+ owners: the administrative complexity of cross-purchase may justify entity redemption, though hybrid structures (using a trust to hold the policies) can address the complexity issue while preserving some of the tax benefits.
For businesses where the owners do not expect to sell: the tax basis difference matters less because there is no exit event to trigger the capital gains. Entity redemption’s simplicity may be the better fit.
The right answer requires a conversation with both an estate attorney and a CPA who understands the specific tax implications for your entity structure (LLC, S-corp, C-corp) and your expected exit timeline.
Frequently Asked Questions
What is a buy-sell agreement?
A contract between business co-owners that specifies what happens to each owner’s interest when a triggering event occurs (death, disability, retirement, departure, divorce, deadlock). It defines who can buy, at what price, and how the purchase is funded.
Why do I need life insurance to fund a buy-sell agreement?
Life insurance provides the immediate cash needed to purchase a deceased owner’s shares. Without funding, the surviving owners or the business must come up with the purchase price from other sources, which may not be available. The death benefit arrives tax-free and provides certainty of funding.
What is the tax difference between cross-purchase and entity redemption?
In a cross-purchase, the surviving owner’s tax basis is stepped up to the purchase price, reducing capital gains at the eventual exit. In an entity redemption, the surviving owner’s basis does not change, resulting in a higher capital gains tax when the business is sold. The difference can be 15-25% of the capital gains tax bill.
How often should a buy-sell agreement be updated?
Every 2-3 years, or when a material event occurs (significant change in business value, new owner added, owner exits, major change in financial condition). The valuation formula and insurance coverage amounts should reflect the current value of the business.
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