Here's a scenario no business owner wants to think about: you and your partner have built something amazing together, and then suddenly, your partner passes away. Their spouse now owns half your business. Or maybe their estate needs cash immediately and wants to sell to the highest bidder—who might be your competitor. Without a plan in place, everything you've built could unravel overnight.
That's exactly what a buy-sell agreement funded with life insurance prevents. It's essentially a business prenup that spells out what happens to ownership interests when someone dies, becomes disabled, retires, or wants out. And when you fund it with life insurance, you're guaranteeing the money will be there when it's needed most.
Why Life Insurance Is the Smart Funding Choice
You could fund a buy-sell agreement several ways: saving cash over time, taking out a loan when needed, or using life insurance. But here's the reality—saving enough cash takes years, and you can't predict when you'll need it. Loans require approval and come with interest costs. Life insurance, on the other hand, creates immediate liquidity the moment the triggering event happens.
Think about it this way: if your business is worth $2 million and you have two equal partners, each owner would need a $1 million policy on the other. When one partner dies, the surviving partner receives $1 million tax-free to buy out the deceased partner's share. The departing family gets fair value in cash, and the surviving owner maintains control. Everybody wins.
The shocking part? Only 20% of small businesses actually have business life insurance in place. That means 80% of business owners are hoping for the best, despite knowing their business would suffer financially if an owner died or became disabled. Don't be part of that statistic.
Cross-Purchase vs. Entity Purchase: Which Structure Is Right for You?
There are two main ways to structure your buy-sell agreement: cross-purchase and entity purchase. Each has distinct advantages, and the right choice depends on your specific situation.
In a cross-purchase agreement, each owner personally buys life insurance policies on the other owners. So in a three-owner business, you'd need six policies total (each person owns a policy on the other two). When an owner dies, the surviving owners use their policy proceeds to buy out the deceased owner's share directly. The big advantage? You get a "step-up" in tax basis on the purchased shares, which means you'll pay less in capital gains taxes if you eventually sell the business.
In an entity purchase agreement, the business itself buys one policy on each owner and pays the premiums. When an owner dies, the company receives the death benefit and uses it to redeem that owner's shares. This is much simpler administratively—instead of six policies for three owners, you only need three. But surviving owners don't get that tax basis step-up.
Here's where it gets interesting: in 2024, the Supreme Court ruled in Connelly v. United States that life insurance proceeds received by a company under an entity purchase agreement increase the company's value for estate tax purposes, but the company's obligation to buy back shares doesn't reduce that value. This ruling has made cross-purchase agreements more attractive for some businesses, especially those with significant estate tax concerns.
The bottom line: if you have two or three owners and want maximum tax efficiency, cross-purchase usually wins. If you have five or more owners, the administrative complexity of cross-purchase (you'd need 20 policies for five owners!) makes entity purchase the practical choice.
Triggering Events: When Does the Agreement Kick In?
A well-crafted buy-sell agreement spells out exactly which events trigger a buyout. The most common triggering events include death, disability, retirement, voluntary exit, divorce, bankruptcy, and irreconcilable disputes between owners. You want clarity here—vague language leads to lawsuits later.
Death is straightforward—the life insurance pays out, and the buyout happens according to your agreement. But what about disability? You'll want to define exactly what "disability" means (usually unable to work for 6-12 months) and consider disability insurance to fund those buyouts, since life insurance won't help here. Retirement provisions should specify the age or circumstances when an owner can trigger a buyout. Voluntary exits might include different terms—maybe the departing owner gets paid out over time rather than all at once.
Here's something many business owners miss: you can use different valuation methods for different triggering events. For example, an owner who files bankruptcy might receive a lower valuation than one who's retiring in good standing. This prevents someone from gaming the system.
Valuation Methods: What's Your Business Really Worth?
This is where things get real. Your buy-sell agreement is only as good as your valuation method. Get it wrong, and you'll either overpay (draining the business) or underpay (creating resentment and potential lawsuits). There are three main approaches.
The fixed price method is simple—you agree on a dollar amount and write it into your agreement. The problem? Most owners never update that number, so when a triggering event happens five years later, the valuation bears no resemblance to reality. If you go this route, commit to updating the valuation annually.
The formula approach uses your company's financial metrics to calculate value. The most common formula multiplies your EBITDA (earnings before interest, taxes, depreciation, and amortization) by an industry-standard multiple—typically 2 to 3 times for small businesses. So if your business earns $500,000 in EBITDA and your industry multiple is 2.5, your business would be valued at $1.25 million. This method automatically adjusts for business performance, but make sure your formula reflects how buyers actually value businesses in your industry.
The independent appraisal method brings in a professional business appraiser when a triggering event occurs. It's the most accurate and defensible approach, but it's also expensive (often $10,000 or more) and can delay the transaction. Many agreements use a hybrid approach: formula-based valuation with the option for either party to request an independent appraisal if they disagree with the result.
Term vs. Permanent Life Insurance for Buy-Sell Funding
Most buy-sell agreements use term life insurance because it's affordable and provides coverage when you need it most—during your prime working years. A 20- or 30-year term policy gives you coverage while you're building the business and can be renewed or adjusted as needed. The premiums are usually tax-deductible as a business expense in entity purchase agreements.
Permanent life insurance (whole life or universal life) costs more but builds cash value over time and provides lifetime coverage. This can make sense if you're planning to work well into your 60s or 70s, or if you want to use the policy's cash value as a funding source for retirement buyouts. Some businesses use permanent insurance as a dual-purpose asset—buy-sell funding plus supplemental retirement income.
How to Get Started with Your Buy-Sell Agreement
If you don't have a buy-sell agreement yet, start the conversation with your co-owners today. Seriously—today. These discussions are easier to have when everyone's healthy and getting along. Once there's conflict or a health scare, emotions run high and positions get entrenched.
Work with an experienced business attorney to draft your agreement—this isn't a DIY project. Your attorney should work alongside your accountant and insurance advisor to structure the agreement tax-efficiently. Get your business formally valued by an appraiser so you know how much insurance coverage you need. Then work with an insurance agent who specializes in business insurance to get quotes on appropriate policies.
A buy-sell agreement funded with life insurance is one of the smartest investments you can make in your business's future. It protects your family, your co-owners, and everything you've worked to build. The peace of mind alone is worth it—knowing that whatever happens, your business will continue and everyone will be treated fairly. Don't wait for a crisis to create a plan. Get started today.
