Buy-sell and key-person coverage: funding the moment an owner leaves

A business with more than one owner needs written terms for death, disability, retirement, and other departures. Insurance may fund some obligations, but the agreement, valuation method, ownership, beneficiaries, and policy design have to work together.

Compare the obligation with the available money

An agreement may require a purchase even when the intended funding is missing. Start with the event that would require a buyout and the method used to set its price. Then confirm whose life the insurance covers, who owns the policy and who receives the proceeds. Counsel should resolve any mismatch between the purchase obligation and the funding arrangement.

Who will buy the departing owner's interest?

A buy-sell agreement defines what happens to an owner's interest after specified events. The agreement and applicable law determine the obligations; insurance funds only the events and amounts covered by the policy.

In a cross-purchase arrangement, the remaining owners buy the departing owner's interest. When life insurance funds the purchase, owners generally hold policies on one another. Under an entity-redemption arrangement, the business buys back the interest and may own the funding policies. A wait-and-see agreement leaves room for the business or remaining owners to make the purchase under its stated terms.

These arrangements can produce different tax basis, valuation and ownership results. Have tax and legal counsel compare them for the actual entity and proposed purchase before choosing how to own the insurance.

What Connelly means for an insurance-funded redemption

In June 2024, the Supreme Court held in Connelly v. United States that a corporation's obligation to redeem shares at fair market value did not offset the life insurance proceeds included in the corporation's value for federal estate-tax purposes. The proceeds intended to fund a buyout could therefore increase the value of the deceased owner's interest.

Have counsel review an entity-redemption arrangement funded with corporate-owned insurance in light of that holding. The federal basic exclusion amount is $15 million per individual in 2026, but that figure alone does not establish whether an estate owes tax. The owner's other assets, prior gifts and applicable state taxes also matter. Review the agreement's valuation terms and the funding together.

Funding the agreement with life and disability coverage

Life insurance can provide cash when an owner’s death triggers a buyout. Compare the death benefit with the amount the buyer would owe. If insurance funds only part of the price, identify where the rest would come from. Revisit that comparison when the business value or agreement changes.

Where the design supports it, available cash value may contribute to a retirement buyout. Review access, surrender charges, taxes and the effect on continuing coverage rather than assuming the illustrated value will fund the obligation.

A buy-sell agreement may also define disability as a triggering event. Disability buyout coverage can fund some or all of that obligation when the policy's definition and waiting period are met.

Key-person coverage is a separate tool

Key-person insurance is distinct from buy-sell funding. The business owns a policy on an individual whose loss would significantly damage the company's finances, whether a founder, a lead salesperson, or a technical specialist. The business is both owner and beneficiary, and the proceeds can offset lost revenue or fund the cost of finding and training a replacement. Estimate the financial disruption and the cost of replacing that person's work, then ask the carrier what coverage it will consider. Salary or a revenue multiple alone may not capture the loss. Revisit the amount when the business or the role changes.

Before an employer-owned policy is issued, have counsel confirm whether IRC Section 101(j) applies and what notice and written consent are required. The rules also consider the insured’s status and other conditions. Form 8925 addresses annual reporting for applicable contracts; a tax professional should establish the business’s obligations.

Assign the review when ownership changes

Keep the agreement, valuation and policy schedule together. A new owner, a revised purchase price or a change in entity structure should prompt a review of all three. Record who will obtain legal and tax advice and who will update the insurance; otherwise the agreement and its funding can drift apart again.

This is general education. Agreement terms, valuation, coverage and tax treatment require review by the owners' legal, tax and insurance professionals.