Buy-Sell Agreements, Life Insurance & Business Valuation: What Owners Must Know

Business owners are often reluctant to plan for the eventual transition of ownership, even though the need for succession is inevitable, whether it comes through retirement or unforeseen circumstances. Too often, the process is delayed because it feels premature, uncomfortable, or overwhelming.

Some believe that having life insurance or a signed agreement in place is sufficient. Others intend to address the issue eventually but never quite get there. What may seem like a solid foundation often reveals gaps under stress—mismatched ownership, outdated valuations, unnecessary tax exposure, or legal language that no longer reflects the business’ current structure or intent.

At its core, this process is about much more than documents and signatures. It’s about safeguarding the future of your business and the legacy you’ve worked so hard to build.

When Ownership Changes Hands

When the owner of a closely held company passes away, control does not automatically transfer to the surviving partner. Instead, ownership typically passes to the deceased’s heirs, who may have little interest or experience in running operations. This can leave business partners unexpectedly working with family members who have different priorities, goals, or knowledge of company operations.

This shift can lead to significant challenges. Day-to-day decisions may stall. Disagreements may arise over the company’s direction, cash flow, or reinvestment strategies. If the heirs want to cash out, the business may lack the liquidity or readily available cash to buy them out, especially during a period of transition or grief.

This is where a buy-sell agreement plays a critical role. A buy-sell agreement is a legal contract that outlines how a partner’s share of a business will be reassigned if they pass away or leave the business. It outlines who will purchase the deceased’s ownership interest, how the price will be set, and how the transaction will be funded. Life insurance is often a key funding tool in this arrangement because it can provide the liquidity needed at the right time. But the benefits of life insurance are not automatic; they require careful planning.

Key Components for a Successful Buy-Sell Agreement

A well-crafted buy-sell agreement ensures surviving owners can buy out the deceased partner’s share without involving family members or external parties who may have no interest in the business. However, this process depends on a few critical elements:

• Ownership Structure. Clear ownership percentages and responsibilities help avoid confusion or disagreements when the buyout process begins. Without a defined structure, surviving owners may struggle with a misaligned or outdated agreement.
• Funding Mechanisms. Even a well-designed buy-sell agreement can falter if adequate funding for the buyout is not in place. Life insurance is commonly used to provide liquidity, but the policy must be properly structured to avoid unintended tax consequences.

The Role of Life Insurance in Succession Planning

Life insurance is often central to a buy-sell agreement because it provides the necessary funds to buy out a deceased owner’s share, keeping the business intact. However, the role of life insurance in succession planning is frequently misunderstood.

For example, if the business directly pays the premiums on a policy intended to benefit the individual owners, the IRS may classify the death benefit as taxable income, reducing funds available for the buyout. This can complicate what should be a straightforward process.

An Irrevocable Life Insurance Trust (ILIT) is one solution that keeps the death benefit outside the insured person’s taxable estate, helping prevent estate taxes from reducing the payout. However, using an ILIT requires careful management. Timely premium payments and regular reviews are essential to ensure the trust remains aligned with both business needs and evolving tax laws.

Valuation That Holds Up

Valuations must be updated regularly and must be defensible to avoid IRS scrutiny, tax exposure, or potential disputes between business partners and heirs. To avoid issues, valuations should be based on current market conditions and supported by independent appraisals. Discounts—or reductions in value applied because the business interest cannot be easily sold or does not carry decision-making power, for lack of marketability or control—may be appropriate in some cases, but they must be consistently applied and well-documented. A mismatch between assumed and actual value can derail the buyout process or invite IRS scrutiny.

What a Strong Buy-Sell Agreement Should Include

A well-structured buy-sell agreement provides clarity and stability, but only if it reflects the business’s current realities. Key elements include:

• Updated valuation formulas that reflect the company’s current worth
• Properly funded and correctly owned life insurance policies to support liquidity
• Clearly defined payment terms that account for timing and structure
• Regular revisions to address changes in ownership, value, or business goals
• Clear treatment of voting and non-voting shares, including whether share premiums apply
• Thoughtful consideration of recapitalization strategies and valuation discounts, with appropriate documentation and application

With regular reviews, the agreement can remain aligned with business goals, tax regulations, and evolving ownership dynamics.

What Coordinated Planning Looks Like

Strong succession and estate plans are built on coordination. The goal is to create a structure where all moving parts—legal documents, valuations, insurance, ownership, and tax strategies—support one another. A comprehensive plan addresses:

• Ownership of life insurance policies to align with intended tax treatment
• Premium payment methods and any applicable deductions
• Valuation approaches that advisors agree are reasonable and defensible
• Consistent trust, entity, and beneficiary designations across all documents
• Scheduled reviews to adjust for funding, ownership, or goal changes
• Recapitalization strategies that support planned buyouts or future control shifts

When the structure is cohesive, business owners gain clarity, reduce tax exposure, and create a smoother path forward for the next generation.

How We Help

We help clients navigate complex tax matters with clarity and coordination. Whether the goal is to reduce liability, plan for a transition in ownership, or prepare the next generation, our team brings structure to the process and confidence to each decision. We work closely with your advisors to align tax planning, succession strategies, and wealth preservation with your long-term goals.

Clients come to us with questions, but what they value most is our ability to look beyond the issue at hand. We help identify risks before they interfere with outcomes—supporting transactions, guiding multigenerational planning, and ensuring that your financial strategy evolves with your life, your enterprise, and your legacy.

These insights were contributed by Joshua England, LLM, Esq., Partner & Tax Attorney, AAFCPAs, and Daniel Seaman, CPA, Tax Partner, AAF Wealth Management. Questions? Reach out to our authors directly or your AAFCPAs partner. AAFCPAs’ blog offers a wealth of resources related to exit planning, managing wealth, and tax strategy.