Buy-Sell Agreements in 2026
The Hidden Tax Trap Most Business Owners Haven’t Fixed
After Connelly v. United States (2024), entity-purchase buy-sells funded with company-owned life insurance now inflate the estate value of the deceased owner — sometimes by millions. Most existing agreements need to be reviewed. Many need to be restructured.
The Quick Read
Every multi-owner business has a buy-sell agreement. Almost none of them have been reviewed since the U.S. Supreme Court ruled Connelly v. United States in June 2024. The decision held that life insurance proceeds owned by a company to fund a redemption of a deceased owner's shares increase the company's value at death — meaning a $3M policy bought specifically to fund the buyout can add $3M of estate-tax exposure to the owner's estate. Three funding structures exist: cross-purchase, entity-purchase (redemption), and wait-and-see. Post-Connelly, the right answer for most $500K–$10M revenue businesses is no longer entity-purchase.
- Why Buy-Sell Agreements Quietly Fail
- The Three Funding Structures, Visualized
- Cross-Purchase: Each Owner Insures the Others
- Entity-Purchase: The Business Insures Each Owner
- Wait-and-See: The Hybrid Most Tax Counsel Now Recommend
- Connelly v. United States: The 2024 Decision That Changed Everything
- Valuation Methodology: How the Number Gets Set
- Worked Example: A Charlotte Three-Partner Engineering Firm
- Frequently Asked Questions
A buy-sell agreement is the contract among co-owners of a closely-held business that determines what happens to a departing owner's interest at death, disability, or voluntary exit. Almost every multi-owner business has one. Almost none have been pressure-tested against the way the law has actually evolved.
The June 2024 Supreme Court decision in Connelly v. United States reshaped the landscape for the most common buy-sell structure used by closely-held businesses — the entity-purchase (redemption) agreement funded with company-owned life insurance. The Court held, unanimously, that the life insurance proceeds the company receives at the death of an owner increase the value of the company for federal estate tax purposes. The buyout proceeds inflate the estate. The result for the family of the deceased owner: a federal estate tax bill substantially higher than anyone expected when the agreement was signed.
This piece walks through the three funding structures, the post-Connelly tradeoffs, the valuation discipline that determines whether the price set by the agreement actually controls under §2031 and §2703, and how a multi-owner business should be reviewing its current agreement in 2026.
Why Buy-Sell Agreements Quietly Fail
The most common failure mode is not that an agreement does not exist. It is that the agreement was drafted years ago, the funding mechanism was selected based on simplicity at the time, and nothing about it has been revisited as the business has grown, the partner count has changed, or the law has moved underneath it.
Three things tend to break first. The valuation formula, often pegged to a multiple of book value or a stale appraisal, no longer reflects what the business is actually worth — meaning the surviving owners pay too much (or the family receives too little). The funding mechanism, often selected when the company had three partners and an entity-purchase felt simpler, no longer makes tax sense at five partners or after Connelly. And the documentation, often drafted at formation and never updated, no longer reflects the actual operating reality of who does what and what the agreement is supposed to govern.
Buy-sell failures are quiet. The agreement sits in a drawer; the policies sit in force; the premiums get paid. Then something happens — an owner dies, an owner becomes disabled, an owner wants out — and the structure that everyone assumed would deliver a clean buyout produces a dispute, a tax surprise, or a forced liquidation. The work is in the review, not the drafting.
The Three Funding Structures, Visualized
Three structures dominate the buy-sell landscape: cross-purchase, entity-purchase (redemption), and wait-and-see. Each has different mechanics, different tax outcomes, different complexity at scale, and now, post-Connelly, different estate inclusion implications.
Cross-Purchase: Each Owner Insures the Others
In a cross-purchase structure, each owner personally holds and is the beneficiary of life insurance policies on every other owner. At a death, the surviving owners receive the insurance proceeds personally and use them to buy the deceased owner's interest from the estate.
The advantages are significant. The acquired interest receives a basis step-up to the purchase price — meaning if the surviving owners later sell, they pay capital gains only on appreciation above the buyout price, not from zero. The insurance proceeds are not received by the company, so they do not increase the company's value for estate tax purposes — eliminating the Connelly problem entirely. And the surviving owners' equity stake genuinely increases on a tax-clean basis.
The disadvantage is policy count. The number of policies grows as the square of the number of owners. Three owners require six policies (each owner holds policies on the other two). Five owners require twenty. Ten owners require ninety. At larger partner counts, the administrative burden becomes unworkable, which is why entity-purchase historically dominated for groups above three or four owners.
Cross-purchase variants — the insurance LLC, the trusteed cross-purchase — have been developed to reduce policy count by having a single entity hold policies for the benefit of multiple owners. These structures retain most of the cross-purchase benefits while reducing the administrative count, but require careful drafting to avoid transfer-for-value problems under §101(a)(2).
Entity-Purchase: The Business Insures Each Owner
In an entity-purchase (redemption) structure, the business itself owns and is the beneficiary of life insurance policies on each owner. At a death, the company receives the proceeds and uses them to redeem the deceased owner's interest from the estate. One policy per owner regardless of partner count. Administratively simple at scale.
The historical disadvantages were tax-based: redemption proceeds may be treated as a dividend rather than a sale under §302 if redemption requirements are not met; surviving owners do not receive a basis step-up because they did not purchase the interest personally; and the corporate alternative minimum tax once posed an issue for C-corps with significant insurance holdings.
The post-Connelly disadvantage is severe. The Supreme Court held in 2024 that life insurance proceeds owned by the company increase the company's value at the moment of the insured owner's death — meaning the deceased owner's pro rata interest in the company is now valued at a number that includes the policy proceeds the company receives to redeem him. The estate is taxed on a value that includes the very money the company used to buy out the estate. This essentially doubles the asset for inclusion purposes.
For owners with estates above the federal exemption, this can mean millions of additional federal estate tax. For owners below the federal exemption but in state estate tax states, it can pull the estate above thresholds it otherwise would have cleared.
Wait-and-See: The Hybrid Most Tax Counsel Now Recommend
The wait-and-see structure (sometimes called a hybrid or option agreement) combines elements of both. The agreement typically gives the entity a first option to redeem the deceased owner's interest. If the entity declines or fails to redeem within a defined window, the surviving owners have the right (or obligation) to purchase personally. Insurance funding is structured flexibly — sometimes held by an ILIT, sometimes by the owners personally, sometimes by the entity in part — with the structure of the buyout determined by the actual circumstances at death.
The advantages: maximum flexibility to adapt to changing tax law (Connelly being the textbook example), the ability to elect cross-purchase treatment if entity-purchase has become unfavorable, and preservation of basis step-up where structurally possible. The disadvantage: more complex drafting and a higher reliance on the integrity of the documents at the moment of death — if the agreement is ambiguous about who has the option and when, disputes follow.
Post-Connelly, wait-and-see is the recommended structure for most newly drafted agreements involving multi-owner businesses with significant value.
Connelly v. United States: The 2024 Supreme Court Decision That Changed Everything
The facts of Connelly v. United States, 144 S. Ct. 1406 (2024), are simple enough to fit on an index card. Two brothers, Michael and Thomas Connelly, owned Crown C Supply, a closely-held building materials company. Michael owned 77.18%; Thomas owned 22.82%. The company carried $3.5M of life insurance on each brother, intended to fund a redemption of his shares at death.
Michael died in 2013. Crown received the $3.5M of life insurance proceeds and redeemed his shares from his estate. The estate's tax return valued Michael's 77% interest at $3.0M — reflecting an appraised value of the company that did not include the $3.5M of insurance the company had just received. The IRS disagreed and assessed estate tax on a higher value — roughly $5.3M for Michael's interest — reasoning that the insurance proceeds increased the company's value at the moment of death, before the redemption transaction occurred.
The Supreme Court agreed with the IRS, unanimously. Justice Thomas wrote the opinion. The holding: a corporation's contractual obligation to redeem shares is not a liability that reduces the corporation's value for estate tax purposes. The insurance proceeds the company received are an asset of the company. The deceased owner's pro rata interest in the company at death includes that asset. The redemption transaction that follows is irrelevant to the §2031 valuation question.
The result for the Connelly estate: roughly $1.0M of additional federal estate tax. The result for every closely-held business operating an entity-purchase buy-sell with company-owned life insurance: a structural problem that did not exist before June 2024 and now does.
Valuation Methodology: How the Number Gets Set
Independent of the funding structure, the agreement's valuation methodology determines the price at which the buyout occurs. Three methods are common: a fixed price (revisited periodically), a formula price (e.g., a multiple of trailing earnings or book value), and a defined appraisal process (typically a single appraiser or a panel).
For the price set by a buy-sell to actually control for federal estate tax purposes, the agreement must satisfy §2703: the agreement must be a bona fide business arrangement, must not be a device to transfer property to family for less than full and adequate consideration, and the terms must be comparable to similar arrangements entered into by persons in arm's-length transactions. Family-controlled businesses face the highest scrutiny on §2703 compliance; non-family multi-owner businesses generally clear the bar more easily.
The defensible practice is to refresh the valuation methodology every two to three years, document any updates with formal amendments, and ensure the formula or appraisal process produces results consistent with what an unrelated buyer would pay.
Worked Example: A Charlotte Three-Partner Engineering Firm
"Anders Engineering," Charlotte 3-Partner S-Corp, $9M Enterprise Value
Three engineering partners founded Anders Engineering in 2008. Each owns one-third. The firm is now valued at roughly $9M. The original buy-sell, drafted by their formation attorney, is an entity-purchase agreement funded with $3M of company-owned term life insurance on each partner ($9M total of in-force coverage). The agreement values each partner's interest at one-third of net asset value, last formally appraised in 2019.
Two problems surface in a 2026 review.
Problem 1 — Stale valuation:
Net asset value formula significantly understates current
enterprise value driven by recurring contracts and goodwill
Problem 2 — Connelly inclusion:
At any partner's death, $3M of insurance proceeds inflate
the company's value, increasing the deceased partner's
estate by a corresponding amount
The directional impact at the death of a single partner under the existing structure:
Federal estate tax on Connelly inflation: ~$400K–$1.2M
(depends on estate size relative to exemption)
Surviving partners receive $0 basis step-up:
full $3M would be embedded gain on future exit
The 2026 restructure they implemented: convert the agreement to a wait-and-see hybrid. Each partner's existing policy is repositioned through an Insurance LLC owned by the three partners as members — a single entity holding all three policies, structured to avoid the §101(a)(2) transfer-for-value problem. Insurance proceeds at any death flow to surviving partners through the LLC, who then purchase the deceased partner's interest personally with basis step-up. The valuation formula is replaced with an annual appraisal-based mechanism. Connelly inclusion is eliminated. Basis step-up is preserved. Total drafting and restructuring cost: approximately $18,000. Avoided exposure at any single death: $400K–$1.2M plus the embedded basis benefit.
Illustrative composite. Insurance LLC structures require careful drafting under §101(a)(2) and §1035 to avoid transfer-for-value issues; specific outcomes depend on existing policy structure, partner ages, and state law.
The Buy-Sell Review Checklist
Buy-Sell Agreement Review — What to Examine in 2026
[ ] Funding structure: cross-purchase, entity-purchase, or wait-and-see
[ ] If entity-purchase: Connelly impact modeled at each owner's potential death
[ ] Valuation methodology and date of last refresh
[ ] §2703 compliance for the agreement to control estate-tax value
[ ] Insurance policy ownership, beneficiary, and premium-payer
[ ] §101(a)(2) transfer-for-value review on any policy transfers
[ ] Triggering events (death, disability, voluntary, involuntary)
[ ] Disability buy-out mechanism and funding (separate from death)
[ ] Mandatory vs. optional purchase language at each trigger
[ ] Note terms if buyout is funded by installments rather than insurance
Frequently Asked Questions About Buy-Sell Agreements in 2026
Does Connelly affect my buy-sell if my company is below the federal estate exemption?
It can. The Connelly inflation increases the federal estate value of the deceased owner's interest. For owners whose estates are well below the $15M exemption, the federal effect may be limited. But for owners in state estate tax states (Massachusetts at $1M, Oregon at $1M, Washington at $2.193M, etc.), Connelly can pull an estate above state thresholds even when the federal exemption is unaffected. State estate tax is the more common Connelly trap for $500K to $10M revenue businesses.
Can I just transfer the company-owned policies to the individual owners to avoid Connelly?
Carefully. Transferring an existing policy to a new owner can trigger the transfer-for-value rule under §101(a)(2), causing the death benefit to lose its income tax exclusion. Exceptions exist for transfers to the insured, to a partner of the insured, or to a partnership in which the insured is a partner. Restructuring an existing buy-sell from entity-purchase to cross-purchase requires a transfer pathway that fits within an exception — commonly the insurance LLC structure with a partnership election.
How often should we review our buy-sell agreement?
Every two to three years at minimum, plus immediately following any material event: a change in partner count, a substantial change in business value, a change in funding mechanism, or a material legal development like the Connelly decision. The agreement is a living document. The mistake is treating it as a one-time formation cost.
What if the surviving owners cannot afford to buy out a deceased partner's full interest immediately?
Buy-sell agreements commonly use installment notes for the portion of the buyout price not covered by insurance. The note terms — interest rate (typically AFR), term length (often 5–10 years), security, and acceleration triggers — should be specified in the agreement, not negotiated after a death when one party is grieving and the other is illiquid.
Should I have a buy-sell if I am the sole owner?
In a different form, yes. A sole owner does not have a co-owner buy-sell, but should have a documented succession plan: who takes over operations at death or disability, how the business is valued for the estate, what funding (typically life insurance, often ILIT-owned) is in place to provide liquidity to pay any estate tax or to compensate non-business heirs equitably, and how the family will or will not continue to operate the business. The substance of the planning is similar; the structure is different.
Buy-sell agreements are the type of document that sits in a drawer for ten years and then determines, in a single moment, whether a successful business transitions cleanly or fractures into a multi-million-dollar dispute and tax surprise. The post-Connelly landscape has not made existing agreements automatically wrong — but it has made them automatically worth reviewing.
If your agreement is older than three years, predates Connelly, or relies on entity-purchase funding with company-owned life insurance, this is the conversation worth having before the next triggering event, not after.
This article is for educational purposes only and does not constitute individualized tax, legal, or investment advice. Connelly v. United States, 144 S. Ct. 1406 (2024) is summarized for general reference. Buy-sell restructuring requires coordination among an estate attorney, business attorney, CPA, and financial advisor. Llewellyn Financial is a fee-only, fiduciary RIA based in Charlotte, NC.
