Entity-Purchase Buy-Sell Agreements: When the Business Buys the Interest

When an Entity-Purchase Plan May Not Fit

With only two owners, the advantage in policy count largely disappears. A cross-purchase plan needs two policies, and an entity-purchase plan needs two as well.

For corporations, valuation is a second issue. In Connelly v. United States, 602 U.S. 257 (2024), the Supreme Court addressed how insurance proceeds received by a corporation affect the value of a deceased shareholder's stock. That case involved a corporation redeeming its own shares, which is treated on this site's redemption page.

Unequal ownership can raise a third issue. When interests are unequal, the owners may disagree about how fairly the entity-paid premiums are shared among them.

Tax Treatment of the Entity-Purchase Structure

Premiums. Under 26 U.S.C. § 264(a)(1), "No deduction shall be allowed for... Premiums on any life insurance policy... if the taxpayer is directly or indirectly a beneficiary under the policy." In an entity-purchase plan, the entity is both payer and beneficiary. Its premiums therefore generally fall within this rule.

Death benefit. Section 101(a)(1) provides that gross income generally "does not include amounts received... under a life insurance contract, if such amounts are paid by reason of the death of the insured." Two limits matter here.

The first is transfer for value. Under section 101(a)(2), when a policy is transferred "for a valuable consideration," the exclusion generally may not exceed the sum of the actual value of the consideration and the premiums and other amounts the transferee pays later. Section 101(a)(2)(B) excepts a transfer "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."

The second is section 101(j). An employer-owned life insurance contract is one owned by a person engaged in a trade or business that is, directly or indirectly, a beneficiary under it and that covers an insured who is an "employee" of the trade or business on the date the contract is issued. Under Notice 2009-48, A-5, an "employee" includes "an officer, director, and highly compensated employee." For such a contract, the exclusion is capped at "the sum of the premiums and other amounts paid." The cap is lifted only if a section 101(j)(2) exception applies and the notice and consent requirements of section 101(j)(4) were met "before the issuance of the contract." Neither condition lifts the cap on its own.

One exception, section 101(j)(2)(B)(ii), covers amounts "used to purchase an equity (or capital or profits) interest in the applicable policyholder" from a member of the insured's family, the insured's designated beneficiary, a trust established for the benefit of either, or the insured's estate. By contrast, 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. That describes cross-purchase ownership. It does not describe entity ownership.

Estate tax. Section 2042 includes in the gross estate proceeds receivable by the executor, and proceeds receivable by other beneficiaries where the decedent held "any of the incidents of ownership." Treasury Regulation 26 C.F.R. § 20.2042-1(c)(2) gives examples of those incidents, including "the power to change the beneficiary, to surrender or cancel the policy." For a corporation of which the decedent is the sole or controlling stockholder, 26 C.F.R. § 20.2042-1(c)(6) provides that the corporation's incidents of ownership "will not be attributed to the decedent through his stock ownership to the extent the proceeds of the policy are payable to the corporation"; the decedent is not treated as a controlling stockholder unless, at death, the decedent owned stock with more than 50 percent of the total combined voting power. Valuing the interest itself is a separate question. Where actual sale prices and bona fide bid and asked prices are lacking, Treasury Regulation 26 C.F.R. § 20.2031-2(f)(2) directs that consideration also be given to nonoperating assets, "including proceeds of life insurance policies payable to or for the benefit of the company," to the extent they have not been taken into account in net worth, prospective earning power and dividend-earning capacity. In Connelly, the Court held that the corporation's obligation to redeem the deceased shareholder's shares at fair market value "did not diminish the value of those shares" (602 U.S. at 267). In that case, the corporation's receipt of the proceeds increased the value of the shares. The opinion states that it decides no more than that one valuation question (267 n.2).

The section 101(j) analysis, transfers for value and estate inclusion under section 2042 each need individual review of the contracts involved, by the insurers and a qualified tax professional.

Potential Advantages of the Entity-Purchase Approach

Administration is the most visible difference. Under this structure:

• There is one policy per owner, whatever the number of owners.
• Premiums are paid centrally from entity funds rather than by each owner separately.
• Surviving owners' interests increase without the owners buying policies on each other.
• The entity's obligation is written into the buy-sell agreement, which gives the business a documented succession mechanism.
• Section 101(j)(2)(B)(ii) may preserve the section 101(a)(1) exclusion for proceeds used to buy an equity interest from the persons the section lists, including the insured's family, designated beneficiary and estate. That result holds only if the notice and consent requirements were also met, and whether the exception applies turns on the facts of each contract.

These are features of how the structure is built. They are not assurances of any tax or financial outcome.

Important Considerations

Notice and consent come first. Under section 101(j)(4), before the contract is issued, the employee must be notified in writing of the intent to insure and of the maximum face amount. The employee must give written consent to being insured, including consent that coverage may continue after employment ends. The employee must also be informed in writing that the policyholder will be a beneficiary.

Notice 2009-48, A-13, provides limited relief for an inadvertent failure to meet these requirements. The relief applies only if three conditions are met:

• the policyholder made a good faith effort to meet the requirements;
• the failure was inadvertent; and
• the failure was discovered and corrected no later than the tax return due date for the year the contract was issued.

Notice 2009-48, A-13, adds that a failure to obtain written consent "cannot be corrected after the insured employee has died."

Other points that are weighed include:

• For corporations, Connelly and 26 C.F.R. § 20.2031-2(f)(2) bear on how insurance proceeds affect the value of the stock. 26 C.F.R. § 20.2042-1 bears on estate inclusion.
• A price or formula that has not been updated can produce disputes or unintended estate-tax results.
• Coverage amounts may drift away from the buyout obligation as the business grows.
• Insurance rules, including policy forms and required disclosures, vary by state.
• Insurer forms, procedures, charges and timing vary from insurer to insurer and are confirmed with the insurers involved.

Tax and Legal Coordination for an Entity-Purchase Plan

Several documents govern an entity-purchase arrangement, and they need to agree with one another. The buy-sell agreement is a legal contract. Its terms control the obligation, the triggering events, the price or formula and the funding. The entity's operating agreement, partnership agreement, shareholders' agreement or bylaws need to match those terms.

Coordination typically covers the following points:

• Notice and consent. Written notice and consent under section 101(j)(4) are completed before the policy is issued.
• Annual reporting. Under 26 U.S.C. § 6039I, an applicable policyholder owning employer-owned contracts files an annual return. That return states, among other items, whether it holds a valid consent for each insured employee. Section 6039I also requires the policyholder to keep supporting records.
• Premium cost. Because section 264(a)(1) generally bars a premium deduction here, after-tax cash flow is part of the planning.
• Owners' estates. Each owner's estate plan accounts for the agreement's effect on the value of the interest and on liquidity. Liquidity here means whether the estate has cash available to cover its obligations.
• Moving existing policies. Moving existing policies between owners, or to the entity, can raise section 101(a)(2) transfer-for-value questions.

Alternatives to the Entity-Purchase Structure

The main alternatives each assign ownership and funding differently:

• Cross-purchase agreement. Each owner owns policies on the other owners and buys the departing interest directly. This site's cross-purchase versus entity-purchase comparison addresses which structure may fit.
• Wait-and-see (hybrid) agreement. The entity typically holds a first option to buy, and the surviving owners hold a second option. The choice of buyer is made when the triggering event occurs.
• Unfunded agreement. The obligation exists, but no funding is arranged in advance. The buyer pays from whatever resources are available at the time.

A corporation redeeming its own stock, including the full context of Connelly, is covered on this site's stock redemption page. Overviews of buy-sell life insurance and business succession life insurance place these structures in the wider planning context. The choice among structures turns on the entity type, the number of owners, the owners' tax objectives and other facts specific to the business.

Hypothetical Example: A Three-Owner LLC

This example is hypothetical and uses round figures. It is not a coverage recommendation.

Assumptions:

• An LLC has three equal members, each holding one-third.
• The agreed buyout value of the business is $3,000,000.
• The LLC owns a $1,000,000 policy on each member.

Step 1. The value of each member's interest is $3,000,000 ÷ 3 = $1,000,000.

Step 2. One member dies, and the LLC receives the $1,000,000 death benefit.

Step 3. The LLC pays the $1,000,000 to the member's estate and acquires the one-third interest.

Step 4. Two members remain, each holding one-third of the units still outstanding. Each member's share is now (1/3) ÷ (2/3) = 1/2, or 50 percent. Neither member bought a policy on the other.

Whether the full $1,000,000 is excluded from the LLC's income depends on several facts. These include whether the insured was an employee under section 101(j), whether a section 101(j)(2) exception applies, and whether written notice and consent preceded issuance. Premiums, policy terms and insurer procedures vary and are confirmed with the insurers involved.