Business Valuation for a Buy-Sell Agreement: Setting the Price the Insurance Funds

When It May Not Fit: Conditions That Complicate the Arrangement

Complications tend to arise in a few recurring situations.

• Rapid appreciation. A fixed price set years earlier may sit well below current value, and a policy sized to it may fall short of a later, updated price.
• Family ownership. Under § 2703(b)(2), the agreement must not be "a device to transfer such property to members of the decedent's family for less than full and adequate consideration." Under 26 C.F.R. § 25.2703-1(b)(3), an arrangement is considered to meet all three requirements if more than 50 percent by value of the property subject to it is owned directly or indirectly by individuals who are not members of the transferor's family and that property is subject to it to the same extent as the transferor's property; an agreement among family members alone cannot use that route.
• Corporate redemption after Connelly. In Connelly, proceeds received by the corporation raised the estate-tax value of the decedent's shares, and the corporation's obligation to redeem at fair market value did not reduce that value; the Court did not hold that a redemption obligation can never decrease a corporation's value (267 n.2). An estate in that position may face tax measured on a figure above the price it receives.
• No agreement on method. Owners who cannot settle on a method, or whose formula diverges widely from appraised value, may face disputes at the triggering event.

These describe circumstances only and recommend nothing.

Tax Treatment: The § 2703 Test and the Connelly Rule

The starting rule sets the agreement aside. Section 2703(a) of the Internal Revenue Code provides that, for purposes of its subtitle, which includes the estate tax, value "shall be determined without regard to" any "option, agreement, or other right to acquire or use the property at a price less than the fair market value" or "any restriction on the right to sell or use such property."

Section 2703(b) lifts that rule only for an arrangement that meets "each of the following requirements": it "is a bona fide business arrangement"; it "is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration"; and "its terms are comparable to similar arrangements entered into by persons in an arms' length transaction." Under 26 C.F.R. § 25.2703-1(b)(2), "Each of the three requirements ... must be independently satisfied," and under § 25.2703-1(b)(1)(iii) the terms must be comparable "[a]t the time the right or restriction is created."

The estate-tax valuation regulation adds two points. Under 26 C.F.R. § 20.2031-2(h), "Little weight will be accorded" a price the decedent was free to ignore during life, and even a binding price "will be disregarded" unless the agreement is "a bona fide business arrangement and not a device" to pass shares to family for less than full consideration. That paragraph refers to section 2703 and the regulations under it, including 26 C.F.R. § 25.2703-1, for "special rules involving options and agreements (including contracts to purchase) entered into (or substantially modified after) October 8, 1990." Where actual sale prices and bona fide bid and asked prices are lacking, § 20.2031-2(f)(2) looks to "net worth, prospective earning power and dividend-paying capacity," plus goodwill, the industry outlook, the company's position and management, "the degree of control" the block represents, and listed comparable companies, and also to nonoperating assets, "including proceeds of life insurance policies payable to or for the benefit of the company," to the extent those assets have not been taken into account in net worth, prospective earning power and dividend-earning capacity.

Connelly addressed a corporate redemption, and the Court wrote that "redemption obligations are not necessarily liabilities that reduce a corporation's value for purposes of the federal estate tax." Separately, § 2042 and 26 C.F.R. § 20.2042-1 govern direct inclusion of proceeds, where "incidents of ownership" include the power "to change the beneficiary, to surrender or cancel the policy" or "to pledge the policy for a loan." Business valuation for buy-sell funding, and how the redemption obligation, the proceeds and estate-tax value interact, need individual review of the agreement and contracts by the insurers involved and a qualified tax professional.

Potential Advantages: What a Formally Valued Buy-Sell Can Accomplish

A well-maintained clause offers practical benefits as a general planning matter, though none is assured.

• A pre-agreed method gives owners and families a known exit price, which may narrow disputes when a triggering event occurs.
• Where all three § 2703(b) conditions are met, the agreed price may be respected for estate-tax purposes, which can reduce uncertainty about the interest's value; whether they are met depends on the facts.
• Sizing the face amount to the current price reduces the chance that survivors or the business must find additional cash at a death.
• A formula or periodic-appraisal clause can keep the price current without a full renegotiation at each review.

Important Considerations: Valuation Risks and Gaps

Most problems trace back to a clause or a policy that was set once and left alone.

A stale fixed price may leave the insurance mismatched with the actual obligation. In Connelly, the proceeds the corporation received increased the estate-tax value of the decedent's shares, so an estate in that position may owe tax on a value higher than the redemption price. Every agreement must also meet the separate § 2703(b)(2) device condition, and § 25.2703-1(b)(2) states that showing a bona fide business arrangement alone "is not sufficient" to satisfy it.

A formal appraisal does not end the inquiry. IRS examiners work from the approaches described in IRM 4.48.4 and can reach a different figure. The agreed price and the face amount are separate decisions, and a change to one typically prompts a look at the other. Insurer forms, procedures and timing for changing a face amount vary by insurer and are confirmed with the insurers involved.

Tax and Legal Coordination: What Professionals Review

The price clause is a legal term of a contract among owners, and its estate-tax effect under § 2703 and the Connelly reasoning is among the points qualified tax and legal professionals review. Whenever the agreed price changes, the face amount of each policy is commonly reviewed alongside it.

Premium deductibility follows a general rule. Section 264(a)(1) of the Internal Revenue Code provides that "No deduction shall be allowed for" premiums on a life insurance policy "if the taxpayer is directly or indirectly a beneficiary under the policy."

Death-benefit income tax is a separate question. Section 101(a)(1) generally excludes death proceeds from gross income, subject to the transfer-for-value limit in § 101(a)(2) and, where a policy the business owns is an employer-owned contract (for example, because it covers an owner who is also an employee), § 101(j), which caps the exclusion at premiums and other amounts paid unless a § 101(j)(2) exception applies and the § 101(j)(4) written notice and consent were given before the contract was issued. How business life insurance works explains those rules. Structure, ownership and tax treatment are typically confirmed with qualified tax, legal and insurance professionals.

Alternatives: Other Ways to Set or Fund the Buy-Sell Price

Insurance is not the only way to pay an agreed price.

• Installment purchase. The surviving owners or the business pays the estate over time, with no insurance proceeds involved; the seller's family carries the credit risk.
• Sinking fund. The business accumulates cash toward a buyout, which may be short if a death comes early.
• Outside financing. A loan funds the purchase at the event, on terms that depend on the business's creditworthiness at that time.
• Combination funding. Insurance covers the death trigger, while other mechanisms address disability or voluntary departure.

Each alternative carries its own tax and legal considerations. Whether a cross-purchase or an entity purchase fits a particular business is a separate comparison Business Life Insurance covers on its own page; buy-sell life insurance describes the funding structures in general.

Example (Hypothetical): How a Valuation Clause Affects the Insurance Face Amount

This example is hypothetical. It uses round numbers and simplified assumptions and is not a coverage recommendation or a tax result for any reader.

Assumptions. A closely held C corporation has two owners, each holding 50%. Under a redemption agreement, the corporation owns a $2,000,000 policy on each owner. The agreed price, set three years ago, is $1,500,000 per 50% interest. A current appraisal values each 50% interest at $2,500,000, so the whole company is worth $5,000,000 before any death. The example ignores policy cash values, discounts, premiums, other assets and income tax, and it assumes the agreed price is not respected under § 2703(b).

Step 1: funding gap if the price is updated.

• Updated agreed price: $2,500,000
• Face amount: $2,000,000
• Gap: $2,500,000 − $2,000,000 = $500,000

Step 2: Connelly-style estate value at one owner's death.

• Company value before death: $5,000,000
• Plus proceeds received by the corporation: $2,000,000
• Company value after proceeds: $5,000,000 + $2,000,000 = $7,000,000
• Redemption obligation not subtracted, as in Connelly (where the obligation was to redeem at fair market value); this illustration assumes the same treatment
• Decedent's 50% interest: $7,000,000 × 50% = $3,500,000

Step 3: comparison with the stale price.

• Value used for estate tax in this illustration: $3,500,000
• Price the estate receives under the old clause: $1,500,000
• Difference: $3,500,000 − $1,500,000 = $2,000,000

The figures show how the clause, the face amount and estate-tax value can diverge.