Buy-Sell Life Insurance for an LLC: How the Funding Works

Short Answer: Can Life Insurance Fund an LLC Buy-Sell Agreement?

Yes. Life insurance can fund an LLC buy-sell agreement by providing cash when a member dies. Either the surviving members own policies on one another (cross-purchase), or the LLC owns a policy on each member (entity purchase), and the proceeds buy the deceased member's interest at the agreed price.

This page is written for members of a multi-member limited liability company and their advisers. The buy-sell agreement itself is a legal document that counsel drafts; Business Life Insurance explains the funding side: who owns each policy, who pays and collects, which federal tax rules bear on the arrangement, and which questions remain open for LLCs in particular.

Why a Buy-Sell Agreement Matters for an LLC

Illiquidity at a member's death is the core problem. An LLC's operating agreement, the contract among the members that governs the company, typically says what happens to a member's interest on death, disability or departure. Saying that the survivors may or will buy the interest does not put cash in their hands.

A buy-sell agreement is a contract, either separate from the operating agreement or written into it, that obligates the remaining members or the LLC to buy a departing member's interest at an agreed price or formula. Without funding, the interest may pass to heirs who become unwanted co-owners, or the company may sell assets to raise the price. Life insurance is one way to make the purchase money appear at the moment the obligation arises; it funds the plan rather than being the plan.

How LLCs Are Typically Structured for Ownership and Continuity

Members of an LLC hold membership interests, not shares of stock, and an operating agreement may restrict who can acquire them. An llc operating agreement buy sell provision names who must or may buy, and on what terms.

A buy-sell needs at least two owners. A single-member LLC has no co-owner to buy out, and life cover tied to a single-member LLC's business loan is a separate lending topic.

LLC formation, transfer restrictions and dissolution events are governed by state law, which varies by state. Where an LLC carries on a licensed profession, rules on who may hold an interest also vary by state and profession.

The Triggering Event: What Activates the Buy-Sell Obligation

A buy-sell agreement commonly lists several triggers: a member's death, permanent disability, retirement, voluntary withdrawal, bankruptcy or divorce. Each trigger needs its own price and payment terms, and counsel drafts those terms together with the funding provisions.

Life insurance answers only the death trigger. It pays a lump-sum death benefit to the policy owner when the insured member dies, which is when the purchase obligation falls due. Disability buyout insurance is a separate product built for the disability trigger.

The price is the other half of the trigger. Whether it is a fixed figure, a formula or an appraisal, it determines how much funding the agreement needs. Business valuation for buy-sell funding, along with the other tax questions on this page, needs individual review by the insurers involved and a qualified tax professional.

How Life Insurance Funds an LLC Buy-Sell: The Two Structures

Two ownership patterns dominate.

Cross-purchase. Each member owns, pays for and is the beneficiary of a policy on each other member. At a death, the surviving members collect the death benefit and use it to buy the deceased member's interest from the estate. Because the buyers pay a price, that price generally becomes the starting point for their basis in the purchased interest. Basis is the tax cost figure used to measure gain on a later sale.

Entity purchase (redemption). The LLC owns a policy on each member, pays the premiums and is the beneficiary. At a death, the LLC collects the proceeds and redeems the deceased member's interest. The effect on the survivors' basis is different and depends on the LLC's tax classification.

With more than two members, a cross-purchase multiplies the number of policies, because each member insures every other member. An entity purchase needs one policy per member. A trusteed cross-purchase, in which one party holds the policies for all members, is an industry arrangement sometimes used to reduce the number of policies. Its tax treatment depends on how it is built.

In either structure, the buy-sell agreement, not the policy, decides how the proceeds are applied. For premiums, 26 U.S.C. § 264(a)(1) provides that "No deduction shall be allowed for— (1) Premiums on any life insurance policy … if the taxpayer is directly or indirectly a beneficiary under the policy or contract." The cross-purchase vs. entity-purchase comparison sets the two side by side.

Policy Ownership in an LLC Buy-Sell

Who owns each policy drives the tax analysis. Members own the policies in a cross-purchase, and the LLC owns them in an entity purchase.

Section 101(a)(1) of the Internal Revenue Code provides that gross income "does not include amounts received … under a life insurance contract, if such amounts are paid by reason of the death of the insured." That exclusion has two limits that 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 plus later premiums and other amounts paid by the transferee. 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." Section 101(a)(2)(A) separately provides that the limit does not apply if the contract's basis in the transferee's hands is determined in whole or in part by reference to its basis in the transferor's hands. The Code text does not say whether an LLC member counts as a "partner," or an LLC as a "partnership" or "corporation," for this list, and Business Life Insurance does not resolve that question.

Employer-owned contracts. Section 101(j) generally caps the exclusion for an employer-owned contract at "the sum of the premiums and other amounts paid by the policyholder." The cap is lifted only when 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 section 101(j)(4) written notice and consent came before the contract was issued. An exception without notice and consent does not lift the cap, and neither does notice and consent without an exception.

IRS Notice 2009-48 includes these relevant answers. A-1: 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: if a contract is otherwise described in section 101(j)(3), ownership "by a partnership or sole proprietorship does not prevent the contract from being treated as an employer-owned life insurance contract." A-5: "employee" includes "an officer, director, and highly compensated employee" (within the meaning of section 414(q)). The Notice does not say whether an LLC is a partnership for these rules. How these rules apply to a particular LLC's policies, notices and consents needs individual review by the insurers involved and a qualified tax professional.

Coverage and Funding Considerations for an LLC Buy-Sell

The face amount of each policy is typically sized to the value of the insured member's interest, and that value comes from the buy-sell agreement, not from the insurer. The value depends on the LLC's assets, its earnings and the method the members chose. The business valuation for a buy-sell explains how price clauses are set, and how much buy-sell coverage relates coverage to price.

A fixed face amount can fall behind a growing company. For that reason many agreements provide for periodic revaluation and a coverage review.

Both term insurance, which covers a stated period, and permanent insurance, such as whole life or universal life, are used. The choice turns on the members' ages, how long the obligation is expected to last and other facts about the LLC. Section 264(a)(1) bars a premium deduction when the payer is directly or indirectly a beneficiary. Policy forms and required provisions vary by state, and each insurer's terms, charges and procedures are confirmed with that insurer.