How Much Life Insurance Should Fund a Buy-Sell Agreement?

Ownership, Premiums and Beneficiary in a Buy-Sell Structure

Two structures dominate.

Cross-purchase. Each co-owner owns a policy on each other co-owner's life, pays its premiums and is its beneficiary. At a death, the surviving owner collects the proceeds and buys the deceased owner's interest from the estate.

Entity purchase (stock redemption). The business owns a policy on each owner, pays the premiums, is the beneficiary and uses the proceeds to redeem the deceased owner's interest from the estate.

Section 264(a)(1) of the Internal Revenue Code provides that "No deduction shall be allowed for … Premiums on any life insurance policy … if the taxpayer is directly or indirectly a beneficiary under the policy."

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:

• Transfer for value. Under section 101(a)(2), when a policy is transferred "for a valuable consideration," the exclusion generally cannot exceed the consideration paid plus later premiums and other amounts the transferee pays. Section 101(a)(2)(B) excepts transfers "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."
• Employer-owned contracts. Under section 101(j), the exclusion for an employer-owned contract is capped at the premiums and other amounts paid. The cap is lifted only if a section 101(j)(2) exception applies, either one based on the insured's status or one for amounts paid to the insured's heirs or used to buy an equity interest from them, and the written notice and consent requirements of section 101(j)(4) were met before the contract was issued. Notice and consent alone do not lift the cap, and an exception alone does not lift it either.

IRS Notice 2009-48, A-3, adds that ownership "by a partnership or sole proprietorship does not prevent the contract from being treated as an employer-owned life insurance contract." A-5 notes that "employee" includes an officer, director and highly compensated employee. Transfers of policies between owners, section 101(j) notice and consent, and the valuation of the interests need individual review of the contracts involved by the insurers and a qualified tax professional. The way premium payer, owner and beneficiary fit together is laid out in how business life insurance works.

Key Factors That Affect the Coverage Amount

The agreed price, or the method that produces it, is the main driver. Other factors determine how that price turns into individual policies:

• Each owner's percentage interest. Hypothetically, in a two-owner business valued at $2,000,000 with equal interests, each interest is $1,000,000, and each policy would be sized at $1,000,000.
• The number of owners. In a cross-purchase structure with N owners in which each owner holds one policy on every other owner, the number of policies is N × (N − 1). With four owners, that is 4 × 3 = 12 policies. In an entity purchase, the entity holds one policy per owner.
• Sensitivity to performance. An earnings formula produces a higher price in a strong year and a lower one in a weak year. A fixed price stays current only when it is amended.
• The Connelly decision. The Supreme Court held that the corporation's contractual obligation to redeem the deceased shareholder's shares "did not diminish the value of those shares," and noted that, because the corporation received the insurance proceeds, they increased the value of those shares. Section 2031(a) includes in the gross estate "the value at the time of his death of all property." In a redemption structure, the shares' estate-tax value and the price the estate receives can therefore differ.

The coverage target is the number the agreement produces. The factors that drive premiums are described on the page on business life insurance cost.

Potential Advantages of Coverage Matched to the Price

Matching the death benefit to the price has several practical effects:

• The buyer receives the funds needed to complete the purchase when the trigger event occurs, without selling assets or taking on new debt.
• The deceased owner's estate receives the agreed price, which gives the family liquidity in place of an illiquid business interest.
• The risk that a surviving owner or the entity cannot perform its purchase obligation is reduced.
• The parties avoid a shortfall that would otherwise have to be covered from other sources or settled by renegotiating the price.

On income tax, section 101(a)(1) generally excludes death benefits from the recipient's gross income. That exclusion is subject to the transfer-for-value rule in section 101(a)(2) and, for employer-owned contracts, to the cap in section 101(j). Whether the exclusion applies to a particular contract depends on how that contract was acquired and owned.

Important Considerations and Risks

Each risk below can affect whether the coverage actually performs its funding role:

• Underfunding. If coverage is not updated as the business grows, the buyer receives less than the price and must fund the difference.
• Overfunding. Coverage above the price means premiums are paid on death benefit the agreement does not require. The excess does not raise the price unless the agreement says it does.
• Entity-purchase valuation. The Connelly opinion explains that, because the corporation receives the proceeds, they "increase the value" of the deceased shareholder's shares. The estate's estate-tax value can therefore exceed what a redemption obligation alone would suggest. Broader estate inclusion of life insurance is a separate estate-planning topic.
• Transfer for value. A policy moved between owners or to the entity may lose part of the section 101(a)(2) exclusion unless an exception in section 101(a)(2) applies, and those exceptions fit some structures but not others.
• Section 2703. Section 2703(a) generally provides that, for purposes of the Code's estate and gift tax subtitle, the value of property is determined without regard to an option, agreement or other right to acquire it at a price below fair market value, or to a restriction on the right to sell or use it. Section 2703(b) lifts that rule only if the arrangement meets each of three 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." The Court noted that a redemption agreement's price is "ordinarily not dispositive" for estate-tax value.
• Premiums. Under section 264(a)(1), premiums are not deductible when the payer is directly or indirectly a beneficiary.
• Policy terms. Insurance rules vary by state, and policy terms vary by insurer. Those terms are confirmed with the insurers involved.

When to Review the Coverage Amount

Coverage is usually revisited when the facts behind the price change. Common triggers include:

• A material change in value, such as revenue growth, an acquisition or the loss of a major customer.
• A change in ownership percentages, such as a partial buyout or the admission of a new owner.
• An amendment that changes the price or the valuation method.
• A change in structure, which raises questions about policy ownership, beneficiary designations and the transfer-for-value treatment of any policy transfers.
• A significant change in tax law, or a court decision such as Connelly v. United States.

Some agreements specify a review interval. Where an agreement is silent, the owners and their advisers decide how often to review it, and the right frequency depends on facts no general explainer can know.

Hypothetical Example: Sizing Coverage for a Two-Owner Business

This example is hypothetical. It uses round figures and does not reflect any reader's own result.

Assumptions (hypothetical): two equal co-owners, A and B; a formula in the agreement values the business at $2,000,000; a cross-purchase structure; no premium figures or insurer terms are assumed.

1. Each interest: $2,000,000 × 50% = $1,000,000.
2. Policies: Owner A owns a $1,000,000 policy on B's life, and Owner B owns a $1,000,000 policy on A's life. That makes 2 × (2 − 1) = 2 policies, each sized to the interest it funds.
3. Growth (hypothetical): Five years later the formula produces $3,000,000. Each interest is now $3,000,000 × 50% = $1,500,000. The funding gap per interest is $1,500,000 − $1,000,000 = $500,000.
4. Closing the gap: Bringing the funding back in line would typically involve more death benefit on each life, which is subject to insurability and to each insurer's terms.