Buy-Sell Agreements and Hidden Estate Tax Risks

While opening a business is thrilling, this excitement sometimes prompts owners to proceed with little more than a handshake. Such an approach leaves significant legal and tax issues unresolved.

A buy-sell agreement is one of the most important tools for formalizing an ownership relationship. These legal contracts govern what happens to an owner’s interest upon death, disability, retirement or departure, providing a clear framework for business continuity and estate planning.

At its core, a buy-sell agreement serves two primary functions: It creates a liquidity mechanism and it establishes a valuation framework. By predetermining how ownership interests will be valued and transferred, the agreement offers certainty to surviving owners and heirs.

Typically, a buy-sell agreement addresses:

• The events that trigger a buyout, e.g., death, disability, retirement, termination or criminal conduct
• How the business interest will be valued at that time
• Who has the right or obligation to purchase the interest
• How the purchase will be funded
• The timeline for completing the transaction

Among the many benefits of a carefully drafted buy-sell agreement are its estate planning implications, which are often significant and misunderstood. A central issue is valuation: If an owner dies, what is their interest actually worth for estate tax purposes? In many closely held businesses, this question directly ties to how the buyout is funded, which isfrequently through life insurance, as death benefits are generally received income tax free. However, the tax implications depend heavily on how the agreement is structured.

Life insurance, valuation and the Supreme Court

In the 2024 decision in Connelly v. United States (144 S. Ct. 1406), the U.S. Supreme Court addressed what happens when life insurance purchased to fund a buy-sell agreement inadvertently increases the estate tax value of the deceased owner’s shares.

Michael and Thomas Connelly, brothers who co-owned a business supply company, had a buy-sell agreement stipulating that upon one brother’s death, the surviving brother could either purchase the other’s shares personally or have the company redeem them. The redemption was funded with proceeds from the $3.5 million life insurance policies the company held on each brother.

After Michael’s death, the company received $3.5 million in insurance proceeds. Thomas chose to have the company redeem Michael’s shares for $3 million. As executor, he reported the value of Michael’s shares as $3 million on the estate tax return, arguing that the insurance-funded redemption price established the shares’ fair market value.

However, the IRS contended that when the company received the $3.5 million in insurance proceeds, those proceeds became a company asset, thereby increasing the company’s overall value. The company’s promise to buy back Michael’s shares did not diminish that value; instead, the company was required to pay whatever the shares were actually worth at the time of death.

The Supreme Court agreed, explaining that a buyer looking at the company on the date of Michael’s death would have seen a business with assets that included the $3.5 million in life insurance proceeds. That cash increased the company’s value, which in turn raised the value of Michael’s shares for estate tax purposes.

The obligation to redeem the shares did not function like a debt that reduces value; it simply required the company to exchange cash for shares of equal worth. The ruling underscores a critical point — the structure and funding of a buy-sell agreement directly affect estate tax valuation.

Further tax consequences

The ruling emphasizes that the way a buy-sell agreement is structured and funded can directly impact the estate tax value of a deceased owner’s shares.

But estate tax valuation is not the only tax risk. Structural decisions — particularly regarding who owns the life insurance policy and how the buyout is executed — can also lead to income tax consequences.

One significant concern involves the transfer-for-value rule, which applies when a life insurance policy is transferred for valuable consideration, such as money or property. While life insurance proceeds are generally received income tax-free, this exclusion can be lost, in whole or in part, if the transfer-for-value rule is triggered. When it is, the taxable amount typically equals the policy’s death benefit minus the buyer’s purchase price and any premiums paid after the transfer, subject to statutory exceptions. A poorly structured buy-sell agreement can unintentionally create this outcome.

In addition to transfer-for-value concerns, state law, estate tax planning strategies and income tax basis adjustments also influence the ultimate tax outcome. A poorly drafted agreement may solve a liquidity problem while inadvertently creating a valuation or income tax issue elsewhere.

Why structure and review matter

Business owners forming a new company — and those already operating without a formal agreement — should review their arrangements in light of the Connelly decision. A buy-sell agreement is not merely a business continuity document; it is also a tax-sensitive instrument that can significantly affect the value of an owner’s estate.

Given the technical and evolving nature of the governing rules, consulting with a tax professional experienced in business succession and estate planning is essential to ensure the agreement achieves its intended results without unintended tax consequences.

© YC Partners 2026