Buy-Sell Agreement Funding
When a Co-Owner Dies: How a Funded Buy-Sell Agreement Works
Published October 9, 2026 · Updated October 9, 2026
The Short Answer
When a co-owner dies and a funded buy-sell agreement is in place, the death triggers a contractual purchase. Life insurance on the deceased owner's life pays a death benefit to the buyer, either the surviving owners or the business itself. That money then pays the deceased owner's estate for the ownership interest, at the price or formula the agreement sets.
The people who usually ask this are surviving partners, LLC members and shareholders of closely held businesses. Some are in the middle of a buyout after the death of a partner. Others are setting up an agreement and want to see how it plays out. Business Life Insurance treats the agreement as the plan and the insurance as the money that carries it out.
What Happens When the Agreement Triggers
A buy-sell agreement is a contract that sets the terms on which an ownership interest is sold and bought when a defined event occurs; the funded agreements described here obligate a buyer to purchase, and a departing owner or that owner's estate to sell. Death is the event that matters here. Once a co-owner dies, an agreement written that way binds the estate to sell and the buyer to buy at the agreed price. Whether an agreement obligates both sides or gives only an option depends on its terms.
The sequence usually runs in three steps. First, the death triggers the purchase obligation. Second, the insurer pays the death benefit to the beneficiary named in the policy, which in a funded agreement is the buyer. Third, that buyer pays the estate and takes the interest.
On income tax, 26 U.S.C. § 101(a)(1) provides that "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured." That is a general rule with limits. The two that matter most in buy-sell planning are the transfer-for-value rule in § 101(a)(2) and the cap on employer-owned contracts in § 101(j). What happens to a business when its owner dies with no agreement is a separate question, covered on the Business Life Insurance page on owner death and succession.
Financial Risks When No Funded Agreement Exists
Money is usually the first gap after an unplanned death. Without a funded agreement, the surviving owners may have no contractual right to buy the deceased owner's interest, and no ready cash even if the estate is willing to sell.
The deceased owner's interest passes to the estate and then to heirs, who may have no connection to the business and no interest in running it. Heirs may want cash. Survivors may want control. Each side may hold a different view of what the interest is worth.
To raise a purchase price, survivors may sell business assets, borrow, or find they cannot fund a buyout at all.
Price is often the hardest dispute. Without a pre-agreed price or formula, the estate and the survivors negotiate from scratch, which adds delay and cost. Business valuation for buy-sell funding turns on facts only the parties have. A buy-sell business valuation explainer covers how price clauses are built.
Ownership Risks: Who Inherits the Deceased's Interest
Ownership does not vanish at death; it moves. Under state law, which varies by state, a deceased partner's, member's or shareholder's interest typically passes to the estate and then to the heirs or beneficiaries named in a will or trust.
An heir may end up with full economic rights, such as a share of profits and sale proceeds, but no duty to work in or support the business. In a partnership, state law and the partnership agreement decide whether an heir becomes a substituted partner with management rights or holds only an economic interest. These rules vary by state.
A buy-sell agreement that obligates both sides removes most of that uncertainty: the estate must sell, the buyer must buy, and the surviving owners know who will own the business afterward. For professional practices, rules on who may hold an interest after a death vary by state and profession, and this page does not state them.
Policies sometimes change hands as ownership is restructured, and that raises the transfer-for-value rule. Section 101(a)(2) provides that after "a transfer for a valuable consideration" of a policy, the excluded amount "shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee." Section 101(a)(2)(B) lifts that limit where the transfer "is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer." Policy transfers, employer-owned contract status and valuation all need individual review of the contracts involved with a qualified tax professional.
Operational Risks: Running the Business After a Co-Owner Dies
Day-to-day operations feel a death quickly. The business may lose a decision-maker, a manager or the person who brought in most of the revenue.
Authority can stall as well. Until the deceased owner's interest is transferred, the survivors may lack the votes or signing authority to act on major decisions, depending on the governing documents. Customers, suppliers and employees watching for signs of instability may leave or cancel contracts.
A funded agreement that closes promptly shortens the period in which ownership is unsettled, which supports continuity. The timeline for closing an entity purchase after the triggering event depends on the agreement and, for an employer-owned contract, on 26 U.S.C. § 101(j). The exception in § 101(j)(2)(B)(ii) covers an amount "used to purchase an equity (or capital or profits) interest in the applicable policyholder" from a person described in § 101(j)(2)(B)(i), which includes the estate of the insured, and it applies only if the § 101(j)(4) notice and consent requirements were met. Notice 2009-48, A-6, says such an amount "must be so paid or used by the due date, including extensions, of the tax return for the taxable year of the applicable policyholder in which the applicable policyholder is treated as receiving a death benefit under the contract." Replacing the deceased owner's skills, through key person coverage and management succession, is a separate subject covered elsewhere on Business Life Insurance.
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Who This Page Is For
This page is written for co-owners of closely held businesses, including general and limited partnerships, LLCs taxed as partnerships, S corporations and C corporations. It assumes a funded buy-sell agreement exists or is under consideration, and it takes the surviving owners' side: the agreement has triggered, the death benefit has been or will be paid, and the buyout is underway or being planned.
It is not written for sole proprietors, who have no co-owner to buy the interest. It is not written for businesses with no agreement in place. That situation belongs to the Business Life Insurance page on owner death.
How a partnership's tax year and the partners' basis are treated when a partner dies is outside this page's scope. Owners of professional practices will find that licensing and ownership rules vary by state and profession and are not addressed here. A broader overview appears on the page on life insurance for business owners.
Where Life Insurance May Fit in the Buyout
The insurance answers one narrow question: where the purchase money comes from on the date it is owed. Its mechanics depend on structure.
Cross-purchase. Each co-owner owns, pays premiums on and is beneficiary of a policy on each other co-owner's life. At a death, the surviving owner collects and buys the interest from the estate. The cross-purchase buy-sell page covers this structure in depth.
Entity purchase (redemption). The business owns the policies, pays the premiums and is beneficiary. At a death, the business collects and redeems, or buys back, the interest from the estate.
On premiums, 26 U.S.C. § 264(a)(1) provides that no deduction is allowed for "premiums on any life insurance policy … if the taxpayer is directly or indirectly a beneficiary under the policy." An entity that is beneficiary of its own redemption policies falls within that text.
On proceeds, the § 101(a)(1) exclusion is the general rule. For an employer-owned contract, § 101(j)(1) limits the exclusion to "the sum of the premiums and other amounts paid by the policyholder for the contract." The cap is lifted only where a § 101(j)(2) exception applies and the written notice and consent requirements of § 101(j)(4) were met before the contract was issued. Neither condition alone is enough. Notice 2009-48, A-1, states that a contract "owned by the owner of an entity … (such as for purposes of financing the purchase of an equity interest of another owner)" is not an employer-owned contract. A-3 states that, for a contract otherwise described in § 101(j)(3), ownership "by a partnership or sole proprietorship does not prevent the contract from being treated as" one. Insurance rules on ownership, beneficiary designations and assignment vary by state and by insurer. Comparing the two structures is the subject of a separate Business Life Insurance page on cross-purchase and entity purchase.
When Life Insurance May Not Be the Answer
A funded agreement solves a buyout problem, not every problem a death creates. It does not replace the skills, relationships or revenue the deceased owner provided. That operational loss is the territory of key person coverage.
Coverage can also fall short. If the business has grown, or the agreed price was revised while the policies were not, the death benefit may not cover the full purchase price. A lapsed policy, or an agreement that was never funded, leaves the survivors with the obligation and no matching source of cash.
Structure creates its own friction. In a cross-purchase among several owners, the number of policies rises quickly because each owner insures every other owner. An entity purchase uses fewer policies but has its own tax questions, including, where the contract is employer-owned, § 101(j).
Some owners cannot obtain coverage at a workable cost, and agreements then rely on installment notes, sinking funds or loans. A buy-sell funding alternatives page describes those methods. Whether any of this fits a given business turns on facts this page cannot know.
Planning Options Before a Death Occurs
Structure comes first. In a cross-purchase, the owners buy from one another. In an entity purchase, the business buys from the estate. Each structure differs in who owns the policies, who pays the premiums and how the tax rules apply.
The price clause comes next. A fixed price or formula sets the target the coverage is meant to match, and a figure set years earlier may not reflect value at death. A related Business Life Insurance page covers buy-sell coverage amounts.
Agreements typically name the triggering events, such as death, disability, retirement or voluntary departure, and set the timeline for closing. Policy ownership and beneficiary designations are generally aligned with the agreement, because a mismatch can create tax and legal complications.
In partnership arrangements, the § 101(a)(2)(B) exception for transfers "to a partner of the insured, to a partnership in which the insured is a partner" comes up when policies move as owners change. For employer-owned contracts, Notice 2009-48, A-7, says, of an owner-employee of a wholly-owned corporation, that "actual knowledge alone" cannot substitute for the requirement that notice and consent be "written." A-13 adds that failure to obtain written consent "cannot be corrected after the insured employee has died." Both points need confirmation for the particular contracts.
On estate valuation, the Supreme Court said in Connelly v. United States that a share redemption agreement, although it "may delineate how to set a price for the shares," "is ordinarily not dispositive for valuing the decedent's shares for the estate tax." It held that the contractual obligation of the corporation in that case to redeem a deceased shareholder's shares "did not diminish the value of those shares," because "redemption obligations are not necessarily liabilities that reduce a corporation's value for purposes of the federal estate tax." Comparing buy-sell agreements with broader succession plans is covered separately on Business Life Insurance.
Hypothetical Example: A Two-Partner LLC Buyout at Death
This example is hypothetical, and every figure in it is an assumption.
Assumptions:
- An LLC taxed as a partnership has two equal members, Partner A and Partner B, each owning 50%.
- The agreement fixes the business value at $2,000,000.
- The structure is cross-purchase. Each partner personally owns, pays for and is beneficiary of a $1,000,000 policy on the other.
- No policy was ever transferred, the policies are owner-held rather than employer-owned, and coverage matches the agreed price at death.
Steps:
- Agreed value of each interest: $2,000,000 × 50% = $1,000,000.
- Partner A dies. Partner B, as owner and beneficiary, receives the $1,000,000 death benefit.
- Under 26 U.S.C. § 101(a)(1), amounts paid by reason of the insured's death are generally excluded from gross income. Treatment in any real case depends on the contracts.
- Partner B pays Partner A's estate $1,000,000 for the 50% interest.
- Check: $1,000,000 purchase price = $1,000,000 death benefit received, with no shortfall.
- Result: Partner B owns 100% of the LLC.
Real transactions depart from these assumptions in ways that change the outcome, and this example is not a reader's own result.
Questions to Work Through Before and After a Co-Owner Dies
These questions are typically worked through with qualified tax, legal and insurance professionals. The page frames them; it does not resolve them.
- Does the agreement name the triggering events, the price or formula, and the timeline for closing?
- Does each policy's coverage still match the current agreed value of the interest it funds?
- Who owns each policy, and does that ownership match a cross-purchase or an entity-purchase structure?
- Are the beneficiary designations consistent with who must pay the estate?
- In a partnership arrangement, does the § 101(a)(2)(B) exception reach the way the policies are held, and has a qualified tax professional confirmed it?
- For entity-owned policies, were the written notice and consent requirements of § 101(j)(4) met before issue, and does a § 101(j)(2) exception apply?
- Has the agreement been revisited after any change in owners, value or insurability?
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Frequently Asked Questions
Can a partnership continue if one partner dies?
It can, depending on the partnership agreement and state law, which vary by state. A funded buy-sell agreement gives the surviving partners a contractual right and the cash to buy the deceased partner's interest. Without one, whether and how the business continues is less certain.
Is a partnership dissolved if a partner dies?
Not necessarily. Whether a partner's death ends the partnership depends on state law, which varies, and on the partnership agreement. A buy-sell agreement typically binds the survivors to buy and the estate to sell, which supports continuation. Whether that holds under a given agreement and state law needs confirmation.
What happens to a deceased partner's interest in a partnership?
It typically passes to the estate and then to heirs, depending on state law, the partnership agreement and the will or trust. Without an agreement, heirs may hold economic rights without a management role. A funded buy-sell agreement typically obligates the estate to sell the interest to the surviving partners or to the entity.
Are life insurance proceeds from a buy-sell policy taxable to the surviving partner?
As a general rule, 26 U.S.C. § 101(a)(1) excludes amounts paid "by reason of the death of the insured" from gross income. That rule has limits, including the § 101(a)(2) transfer-for-value rule and, for employer-owned contracts, the § 101(j) cap. Actual treatment depends on the contracts involved.
What is the transfer-for-value rule and how does it affect a partnership buy-sell?
Section 101(a)(2) limits the exclusion after a policy is transferred for valuable consideration, to the consideration paid plus later premiums and other amounts. Section 101(a)(2)(B) excepts a transfer to a partner of the insured or to a partnership in which the insured is a partner. Applying either rule needs individual review.
What is an entity-purchase buy-sell agreement?
It is an arrangement in which the business owns the policies, pays the premiums and is the beneficiary. At an owner's death, the business receives the death benefit and uses it to redeem, or buy back, the deceased owner's interest from the estate.
What notice and consent requirements apply when a business owns a life insurance policy on a partner?
Section 101(j) applies to an employer-owned contract, which among other conditions covers the life of an insured who is an employee on the date the contract is issued. For such a contract, § 101(j)(4) requires that, before issue, the employee is notified in writing of the intent to insure the employee's life and the maximum face amount, provides written consent to being insured and to coverage continuing after employment ends, and is informed in writing that the policyholder will be a beneficiary. Notice 2009-48, A-3, says that, for a contract otherwise described in § 101(j)(3), partnership ownership does not prevent employer-owned status. Notice and consent alone do not lift the § 101(j) cap; an exception must also apply.
Educational information only. Not legal, tax, investment or insurance advice. Product availability and outcomes depend on individual circumstances.