Buy-Sell Agreements After Connelly: Funding and Tax
How co-owners set what happens when one dies or leaves, why the Supreme Court's Connelly decision changed the usual structure, and the basis difference nobody notices until later.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A buy-sell agreement sets how an owner's interest is bought when they die, become disabled, or leave, and at what price. The two structures — surviving owners buy the shares (cross-purchase) or the company buys them (redemption) — are taxed differently. The Supreme Court's 2024 Connelly decision made company-owned life insurance in a redemption plan a problem for estate tax.
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How do the two structures compare?
| Feature | Cross-purchase | Redemption |
|---|---|---|
| Who buys | The other owners personally | The company |
| Life insurance | Each owner insures the others | The company insures each owner |
| Basis to survivors | Survivors get full basis in the shares they buy | No basis increase; survivors' percentage rises but basis does not |
| Number of policies | Many, with several owners | One per owner |
| Estate tax after Connelly | Insurance proceeds are outside the company; no inflation of the deceased's shares | Proceeds increase company value, raising the deceased owner's estate |
| S corporation one-class-of-stock rule | No issue | Redemption terms must not create a second class |
What did Connelly decide?
In Connelly v. United States (decided June 6, 2024), two brothers' company held life insurance to redeem a deceased brother's shares. The Supreme Court held that the insurance proceeds increased the company's value for estate tax, and the obligation to redeem did not offset them. The estate owed tax on a share value inflated by the very policy meant to pay for it. The decision pushed many owners toward cross-purchase structures or insurance held outside the company.
Does the agreement set the estate tax value?
Only if it meets the requirements of Section 2703: a bona fide business arrangement, not a device to transfer the business to family for less than full value, and terms comparable to what unrelated parties would agree. A formula price that is years out of date fails. Agreements among unrelated owners generally hold; family agreements get close scrutiny.
What about the departing owner's tax?
A sale to co-owners or a redemption is generally a capital gain on the shares, provided a redemption qualifies under Section 302 — usually as a complete termination of interest, which in a family company means dealing with the stock attribution rules — rather than being treated as a dividend. Payments for a noncompete or consulting are ordinary income. For a deceased owner, the estate's basis is stepped up to date-of-death value, so a sale at that value produces little gain — the agreement's price matters more for estate tax than income tax.
How should the price be set?
Common methods are a fixed price updated annually, a formula tied to revenue or earnings, or an appraisal at the triggering event. Whichever is used, it should be reviewed yearly; most disputes arise from stale figures.
Frequently asked questions
Can life insurance proceeds be received tax-free?
Generally yes, for both structures, provided employer-owned policies met the notice-and-consent rules and the policies were not transferred for value.
Do we need a buy-sell agreement with only two owners?
Especially then. Without one, a surviving owner may end up in business with the other's heirs.
What funds a lifetime buyout, not just death?
Installment payments from the company or the buyers, sometimes backed by disability buyout insurance.
Does the agreement bind the IRS on value?
Only when the Section 2703 tests are met and the price reflects fair value.
Official sources
The Supreme Court held: “An obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder's economic interest.” — Supreme Court of the United States, Connelly v. United States, 602 U.S. 257 (2024), https://www.supremecourt.gov/opinions/23pdf/23-146_i42j.pdf
The statute provides: “Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements: (1) It is a bona fide business arrangement. (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.” — Legal Information Institute, Cornell Law School, 26 U.S. Code § 2703 - Certain rights and restrictions disregarded, https://www.law.cornell.edu/uscode/text/26/2703
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk reviews existing buy-sell agreements against Connelly and the basis consequences for the owners who remain. See pricing or book a free fit call.
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