Summary. A buy-sell agreement decides what happens to an ownership interest when an owner dies, quits, divorces, becomes disabled, or wants out, and it is the most consequential document most closely held businesses will ever sign. It must answer two questions — what triggers a purchase, and at what price — and the common failure is an agreement that handles the first carefully and the second with a formula nobody has revisited in a decade. This article covers cross-purchase, redemption, and hybrid structures, the full range of triggers and which should be mandatory, the valuation mechanisms and the discount fights they generate, and the funding problem that makes a perfect agreement unenforceable in practice. It also covers the tax rules that reshape these deals, including Connelly.

Two partners own a construction company fifty-fifty. Their agreement says that on the death of either, the company will redeem the deceased owner's interest at "fair market value as determined by an appraiser mutually agreed upon."

One partner dies. The surviving partner and the widow cannot agree on an appraiser. When they finally do, the appraiser values the company at $9 million and applies a 30% discount for lack of marketability, producing $3.15 million for a half interest. The widow's own expert says $6 million with no discount, because she is selling to the only possible buyer and the discount makes no economic sense. The company has $400,000 of cash and a $2 million life insurance policy that the bookkeeper let lapse in 2019 during a cash crunch.

That dispute takes three years, costs both sides several hundred thousand dollars, forces the company to borrow against its equipment, and destroys a relationship between families that had lasted twenty-five years.

Every element of that outcome was decided at drafting. The agreement had a trigger and a price mechanism and looked complete. It failed on the three things that actually matter: it did not specify the standard of value, it did not resolve the appraiser deadlock, and it did not tie funding to an obligation anyone monitored.

What the agreement is for

A buy-sell agreement is a contract among the owners of a closely held business, or between the owners and the entity, governing transfers of ownership interests. It does five things:

  1. Restricts transfers, so that an owner cannot sell to a competitor, a creditor, or an ex-spouse without the others' consent.
  2. Creates a market for an interest that otherwise has none, giving a departing owner or an estate a way out.
  3. Fixes a price mechanism in advance, when nobody knows which side of the transaction they will be on.
  4. Provides liquidity to pay estate taxes and to support a family that loses its income when an owner dies.
  5. Establishes value for transfer-tax purposes, if drafted to satisfy the requirements discussed below.

That third item — pricing before you know your side — is the intellectual core. An agreement negotiated while everyone is healthy and the company is doing well produces terms that are approximately fair to everyone, because nobody knows whether they will be the buyer or the seller. The same terms negotiated after a diagnosis are a fight.

Structure: who buys

Cross-purchase. The remaining owners buy the departing owner's interest individually.

  • Advantage: basis. The buying owners get a cost basis in the purchased interest, which reduces gain on a later sale. In a redemption, the remaining owners' basis is unchanged even though their percentage rises.
  • Advantage: no corporate-law constraints. No surplus or solvency limitation on distributions, and no risk that the purchase is treated as a dividend.
  • Disadvantage: policy proliferation. Funding with life insurance requires each owner to hold a policy on each other owner. Three owners means six policies; five owners means twenty. Premiums are unequal because ages and health differ.
  • Disadvantage: the transfer-for-value trap. If policies change hands — as they do when one owner leaves and the others buy the departing owner's policies on the survivors — IRC § 101(a)(2) can convert tax-free death proceeds into ordinary income. There are exceptions, including transfers to a partner of the insured, which is why partnership-based insurance LLCs are used.

Redemption (entity purchase). The company buys the interest.

  • Advantage: simplicity. One policy per owner, owned and paid by the company.
  • Advantage: administration. The company controls premiums; no owner can let a policy lapse.
  • Disadvantage: no basis step-up for the remaining owners.
  • Disadvantage: corporate-law limits. Most state statutes prohibit a redemption that renders the corporation insolvent or that exceeds available surplus. A redemption that violates those limits can be unwound, and directors who approved it can be personally liable.
  • Disadvantage: dividend risk. For C corporations, a redemption that is not "substantially disproportionate" or a "complete termination of interest" under IRC § 302 is treated as a dividend — ordinary income with no basis recovery. Family attribution under IRC § 318 can defeat what looks like a complete termination when a child remains an owner; a § 302(c)(2) waiver of attribution is available but has conditions, including a ten-year look-forward agreement filed with the return.
  • Disadvantage: the Connelly problem, below.

Hybrid / wait-and-see. The agreement gives the company a first option to buy, then the remaining owners a second option, with a mandatory backstop obligation on one or the other so the seller is guaranteed an exit. This is the most common structure in well-drafted agreements because it preserves flexibility to choose the better tax result when the event happens, years after drafting, under tax law that will have changed.

Draft the backstop as an obligation, not an option. The single most common defect in hybrid agreements is a chain of options with nothing at the end. If nobody must buy, the estate holds an illiquid minority interest in a company controlled by people who have no reason to be generous.

Triggering events

Handle each of these explicitly. Silence on any one of them is where litigation comes from.

Death. Almost always a mandatory purchase. The estate needs liquidity, the survivors need control, and nobody wants a co-owner they did not choose. Consider a short delay to allow insurance proceeds to be received.

Disability. Requires a definition. Options: the definition in the company's disability policy (best, because it aligns funding with obligation), inability to perform material duties for a stated period, or determination by a physician selected under a specified procedure. Specify who selects the physician and what happens on disagreement — typically each side picks one and the two pick a third. Also address partial or intermittent disability and whether the clock resets.

Retirement or voluntary withdrawal. Often a company option rather than an obligation, sometimes with a notice period and a longer payment term to protect cash flow. A company that must buy out any owner who wakes up wanting liquidity is a company that cannot plan.

Termination of employment. Critical in professional and service businesses where ownership is tied to work. Distinguish for cause from without cause and from resignation; it is common and reasonable to price a for-cause departure differently, though a punitive discount can be attacked as a forfeiture in some jurisdictions.

Divorce. Without a provision, an ex-spouse can end up holding an interest in the business under a property division. Standard approach: the divorcing owner must acquire the interest awarded to the spouse, and if the owner cannot, the company or the other owners may purchase it at the agreement price. Reinforce with a spousal consent signed at the outset, and re-execute it when owners marry.

Bankruptcy, insolvency, or creditor attachment. A call right triggered by an involuntary transfer, a charging order, or a bankruptcy filing. Note that ipso facto clauses have limited effect against a bankruptcy estate; the practical protection comes from a transfer restriction plus a purchase right exercisable at a defined price, and from the reality that a charging-order creditor of an LLC member generally receives only distributions, not management rights.

Attempted voluntary transfer. A right of first refusal — the owner brings a bona fide third-party offer, and the company and the other owners may match. Specify the matching period, whether they may match in part, and whether the third party's non-cash consideration must be matched in kind or in cash equivalent.

Deadlock. In a two-owner company, consider a shotgun (buy-sell) clause: one owner names a price, and the other must either buy at that price or sell at that price. It is elegant, self-executing, and dangerous where the owners have unequal liquidity, because the wealthier owner can name a low price knowing the other cannot buy. Mitigate with a minimum price floor tied to appraisal, or with a requirement of financing commitments.

Loss of a license. In professional entities, mandatory. Most professional-corporation statutes prohibit non-licensed ownership outright, so the agreement must force a transfer within a statutory window.

Change of control of an entity owner. If an owner is itself a company or trust, address what happens when that entity changes hands.

Valuation: the part that gets litigated

Three mechanisms, each with a characteristic failure mode.

Fixed price with periodic revaluation

The owners agree on a value and certify it annually.

  • Best case: cheap, certain, no experts, no fight.
  • Actual case: the owners revalue for two years and then stop. Five years later the certificate says $2 million and the company is worth $8 million, and the family of a deceased owner argues the stale certificate should be ignored.
  • Fix: a fallback that engages automatically. "If the certificate is more than eighteen months old at the trigger date, value shall be determined by appraisal under Section X." Put the revaluation on the annual meeting agenda so it is a corporate formality rather than a task nobody owns.

Formula

A multiple of EBITDA, revenue, book value, or a capitalization of earnings.

  • Advantages: objective, cheap, and predictable.
  • Failure modes: formulas do not adapt. A book-value formula understates a services company with no assets. An EBITDA multiple chosen in a boom overstates value in a downturn. A revenue multiple ignores that margins collapsed.
  • Definitional traps: define exactly what EBITDA means — which addbacks, whose accounting, audited or reviewed or compiled, which period, and how owner compensation is normalized. Undefined "EBITDA" is a dispute waiting for a trigger. Specify treatment of debt, cash, working capital, and non-operating assets, because the formula produces enterprise value and the seller is being paid for equity.
  • Fix: a formula with a collar — the formula price, subject to a floor and ceiling set by appraisal, or a right for either side to demand appraisal if the formula deviates from a good-faith estimate by more than a stated percentage.

Appraisal

An independent valuation at the time of the event.

  • Advantage: current and defensible.
  • Disadvantages: slow, expensive, and — unless drafted tightly — a second litigation.
  • Draft the procedure completely:
    • Standard of value. Fair market value? Fair value? Investment value? These are different numbers, and the difference is often 30% or more.
    • Discounts. State explicitly whether minority (lack of control) and marketability discounts apply. This is the single most litigated point. It is also perfectly legitimate to specify no discounts on death and disability (where the family should not be penalized) and discounts on voluntary withdrawal (where the departing owner is choosing to impose a burden).
    • Qualifications. Require a credentialed appraiser (ASA, ABV, CVA) with experience in the industry, and disqualify anyone who has performed work for the company or an owner within a stated period.
    • Deadlock mechanism. Each side appoints; the two appoint a third; the third's determination controls, or the average of the two closest of three, or a "baseball" procedure in which the third appraiser must select one of the two submitted values. Baseball arbitration disciplines both sides toward reasonableness and is underused.
    • Timing and cost allocation. Deadlines that actually run, and a default rule on who pays — often split, or borne by the party whose appraisal is further from the final number.
    • Valuation date. The date of the trigger, not the date of the appraisal, and not the last fiscal year end unless that is intended. Specify whether events after the valuation date are considered.
    • Treatment of life insurance proceeds. See below; this must be addressed expressly.

Fair market value versus fair value. Fair market value, as described in Revenue Ruling 59-60, is the price between a hypothetical willing buyer and willing seller, neither under compulsion, both reasonably informed — and it contemplates discounts for a minority, illiquid interest. Fair value is a statutory concept used in appraisal and dissenters'-rights proceedings and in many oppression statutes, and in most states it means the owner's proportionate share of the enterprise without minority or marketability discounts. If your agreement says "fair value" and you meant "fair market value," you have written a materially larger check.

Section 2703 and the estate-tax value

A buy-sell agreement can fix value for estate-tax purposes, but only if it clears IRC § 2703. Otherwise the price is disregarded and the IRS values the interest at true fair market value — meaning the estate pays tax on a number higher than what it received.

The three requirements, from § 2703(b) and Treas. Reg. § 25.2703-1:

  1. It is a bona fide business arrangement.
  2. It is not a device to transfer property to family members for less than full and adequate consideration.
  3. Its terms are comparable to similar arrangements entered into by persons in an arm's length transaction.

There is also a longstanding common-law requirement, preserved in the regulations, that the agreement bind the owner during life as well as at death — a price that applies only at death and leaves the owner free to sell for more while alive will not fix value.

Cases that show the failure mode. Estate of True v. Commissioner, 390 F.3d 1210 (10th Cir. 2004), rejected a tax-book-value formula used across a family enterprise, in part because no unrelated party would have accepted it and because it had never been adjusted despite dramatic changes in the businesses. St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982), is the classic statement of the four common-law requirements. The recurring lesson is documentation: contemporaneous evidence of the business purpose, comparison to third-party arrangements, and involvement of independent advisors.

Where family members are not involved, § 2703 is generally not a live problem, and an arm's-length agreement among unrelated owners will ordinarily be respected.

Connelly and life insurance

Connelly v. United States, 602 U.S. 257 (2024), resolved a circuit split with consequences for a very large number of existing agreements.

The facts. Two brothers owned a building-supply company. A redemption agreement obligated the company to buy a deceased brother's shares, funded by company-owned life insurance. One brother died; the company received about $3.5 million of insurance proceeds and used $3 million to redeem his shares. The estate reported the company's value excluding the insurance proceeds, on the theory that the proceeds were offset by the redemption obligation.

The holding. A unanimous Supreme Court held that the insurance proceeds are an asset that increases the corporation's value, and that the redemption obligation is not a liability that offsets them. A corporation's contractual obligation to redeem shares at fair market value does not reduce the value of those shares. The company was worth roughly $6.86 million including the proceeds, so the deceased brother's 77.18% interest was worth about $5.3 million — not the $3 million the estate received.

Why that stings. The estate received $3 million and was taxed on $5.3 million. The insurance that was supposed to solve the liquidity problem created a tax problem.

Practical responses, each with tradeoffs:

  • Convert to cross-purchase. Individually owned policies are not company assets, so proceeds do not inflate entity value. Costs: policy proliferation, unequal premiums, transfer-for-value exposure on later policy transfers.
  • Use an insurance LLC or partnership. A separate entity owns the policies; the owners are members. This solves proliferation and, because members of a partnership that owns the policy fall within a transfer-for-value exception, mitigates § 101(a)(2). It requires real formalities and a genuine partnership.
  • Use a trust. An irrevocable trust holds policies and administers the purchase.
  • Keep the redemption structure and price accordingly. Connelly changes the tax consequence, not the legality. Some companies will accept the result, particularly where the estate-tax exemption makes it academic for that family.
  • Revisit the valuation clause. Address expressly whether insurance proceeds are included in or excluded from the agreement price. Note that Connelly governs the estate-tax value regardless of what the contract says; the contract controls only what the estate is paid.

Action item for every existing agreement: determine whether it is entity-funded, whether the owners' estates would be taxable at all given current exemption levels, and whether the structure should change. This is a five-year problem for many families and an immediate one for a few.

Funding

An unfunded buy-sell is a promissory note with extra steps.

Life insurance is the standard answer for death. Points that get missed:

  • Amount. Tie coverage to the agreement's price mechanism, and review it when the formula would produce a materially different number.
  • Ownership and beneficiary must match the structure. Redemption: company owns and is beneficiary. Cross-purchase: each owner owns policies on the others. Mismatches are common and defeat the plan.
  • Monitor premiums. Assign responsibility in the agreement — the company's CFO, in writing, with an annual certification to the board that policies are in force.
  • Insurability. Address what happens when an owner cannot obtain coverage: a reduced price, a longer note, or a required set-aside.
  • Term versus permanent. Term is cheap and matches a defined horizon; it expires, often just as an owner reaches the age when the risk is real. Permanent coverage builds cash value usable for a lifetime buyout.
  • Exit. Provide for transfer of policies when an owner departs, with attention to transfer-for-value.

Disability insurance — buy-out disability policies exist and are rarely purchased. Disability is a more likely trigger than death for owners under sixty.

Installment notes cover everything insurance does not. Specify the term, the interest rate (at least the applicable federal rate to avoid imputed interest), acceleration on default, security (a pledge of the purchased interest, personal guaranties, or a lien on assets), and subordination to the company's senior lender, which will insist on it. Include covenants protecting the seller: limits on distributions, compensation, and new debt while the note is outstanding.

Sinking funds and earn-outs. Less common, but a company with lumpy cash flow may prefer a defined annual reserve, and a departing owner in a business whose value depends on their continued relationships may reasonably be asked to accept part of the price contingent on retention.

Terms that surround the price

A buy-sell rarely stands alone. In a well-drafted shareholders' or operating agreement it sits alongside:

  • Tag-along rights, letting minority owners participate pro rata when a controlling owner sells.
  • Drag-along rights, letting a supermajority force minority participation in a sale — with protections: same price and form of consideration, no representations beyond title and authority, and a cap on indemnity exposure at sale proceeds.
  • Preemptive rights on new issuances, protecting against dilution.
  • Information rights — annual financials, tax information adequate to file returns, and access to records.
  • Distribution policy, particularly mandatory tax distributions in pass-through entities. Without them, a minority owner in an S corporation or LLC can owe tax on income never received, which is the most common form of squeeze in closely held companies.
  • Non-competition and non-solicitation covenants tied to ownership, which in most states are evaluated under the more permissive sale-of-business standard rather than the employment standard.
  • Deadlock and dispute resolution — mediation, then arbitration or a designated court, with a carve-out for injunctive relief.
  • Governance: board seats, supermajority or veto rights over defined major decisions, and officer appointment.

A structural point about transfer restrictions. For corporations, the restriction must be noted conspicuously on the certificate or, for uncertificated shares, in the notice sent to holders, to bind transferees under UCC § 8-204. An unnoted restriction is ineffective against a purchaser without knowledge. Also confirm the restriction is authorized under the state's corporate statute — most permit restrictions that are reasonable, and specifically bless rights of first refusal, options, and consent requirements.

S corporations need protection from themselves. If the entity has an S election, the agreement must prohibit transfers to ineligible holders — nonresident aliens, most entities, and impermissible trusts — and prohibit any arrangement creating a second class of stock. An inadvertent termination is fixable through IRS relief, but only after an expensive and unpleasant process.

How these agreements actually go wrong

A short list of the defects encountered most often in review, in rough order of frequency:

  1. A stale fixed price with no fallback.
  2. "Fair market value" with no statement about discounts. Both sides then hire experts who differ by a factor of two, and neither is wrong under the contract.
  3. An appraisal procedure with no deadlock breaker, so the process cannot start.
  4. Options all the way down, with no mandatory purchaser.
  5. Lapsed or mismatched insurance, discovered at the funeral.
  6. No disability definition, or a definition that requires the disabled owner's cooperation.
  7. No spousal consent, and no divorce trigger.
  8. Payment terms that would bankrupt the company — a lump sum obligation with no financing, no subordination, and no relief valve.
  9. Ignoring the lender. The senior credit agreement prohibits the redemption, and the bank will not consent on the terms the agreement requires.
  10. Never updated. The agreement was signed when there were two owners, an S election, and $2 million of revenue. There are now five owners, a holding company, and $40 million of revenue.

A maintenance discipline

Treat the agreement as a live document with an owner and a calendar.

  • Annually: certify or refresh the value; confirm policies are in force with a carrier statement, not a memory; confirm beneficiary designations; confirm spousal consents cover current spouses.
  • On any ownership change: amend the schedule of owners; add the new owner as a party; issue or reissue certificates with the legend.
  • On any material transaction: check whether the credit agreement, a new investor's rights, or an equity plan conflicts with the buy-sell.
  • Every three to five years, or after a change in tax law: a full legal and tax review. Connelly alone justifies one for every entity-funded agreement in the country.
  • When an owner reaches sixty, or receives a diagnosis: review immediately, understanding that amendments made at that point face both § 2703 scrutiny and skepticism from the other owners.

The reason to do this now

The uncomfortable truth about buy-sell agreements is that the best time to negotiate one is when the topic feels least urgent. Owners who are healthy, getting along, and roughly equally situated will produce a document that is fair, because none of them knows which role they will play. The same owners, after a stroke or a falling-out or an unsolicited offer, will produce either no document or a fight.

The document does not have to be elaborate. A short agreement that says who must buy, on what events, at a price determined by a procedure that cannot deadlock, funded by insurance somebody is responsible for maintaining, payable over a term the company can survive, is worth more than a forty-page agreement missing any one of those elements. Get those five things right and the rest is refinement.

Entity-specific wrinkles

LLCs. The buy-sell lives inside the operating agreement rather than in a separate document, which is cleaner but creates a trap: amendments to the operating agreement may be permitted by a majority vote, meaning a controlling member could theoretically amend the buy-sell terms. Require a supermajority or unanimous vote to amend the transfer and valuation provisions specifically. Address the difference between transferring an economic interest and admitting a member; most LLC statutes make a transferee a mere assignee with distribution rights and no voting or information rights unless admitted, which is a useful default but must be stated. Also address capital account treatment and whether the purchase is structured as a redemption governed by IRC § 736, which for a partnership can convert part of the payment into a deductible guaranteed payment — a meaningfully different economic result for both sides.

Professional entities. Ownership is limited to licensed individuals, transfers to unlicensed persons are void by statute, and the death of a sole owner triggers a statutory wind-down clock that is often as short as six months. Professional practices also carry a valuation peculiarity: much of the enterprise value is personal goodwill attached to the departing professional, and courts in several states distinguish personal goodwill (belonging to the individual, and in some states not a marital or business asset at all) from enterprise goodwill. Address the distinction in the agreement, and pair the buy-sell with covenants that convert personal goodwill into something the practice retains.

Family businesses. Layer in the transfer-tax planning. Interests transferred to the next generation during life are valued for gift-tax purposes with discounts that the buy-sell price may or may not reflect, and a family limited partnership or family LLC structure interacts with IRC § 2704 restrictions on lapsing rights. Coordinate the buy-sell with grantor trusts, GRATs, and sales to intentionally defective grantor trusts rather than drafting each in isolation — the most common failure is an estate plan that transfers interests the buy-sell then requires the company to purchase back from the trust.

Companies with institutional investors. Venture and private equity investors bring their own transfer architecture: rights of first refusal and co-sale agreements, drag-along thresholds tied to board and preferred approval, and redemption rights running to the preferred. A founder buy-sell drafted before the financing usually conflicts with it, and the financing documents will supersede. Reconcile them at the closing rather than discovering the conflict at a founder's departure.

A worked example

Three owners of a distribution business, each one-third. Revenue $22 million, normalized EBITDA $2.6 million. They agree on this structure:

Price. Enterprise value equals 4.5× trailing twelve-month EBITDA as defined in an exhibit that lists permitted addbacks and normalizes owner compensation to market. Equity value equals enterprise value plus cash minus funded debt, adjusted for a working capital target. Either party may demand an appraisal if it believes the formula misstates value by more than 20%, and in that case value is the average of the two closest of three appraisals. No minority or marketability discount applies on death, disability, or termination without cause; a 15% discount applies on voluntary withdrawal within five years.

Structure. Hybrid. On any trigger, the company has 30 days to elect to redeem; if it declines, the other owners may purchase pro rata within 30 days; if they decline in whole or part, the company must purchase the remainder — the mandatory backstop.

Funding. Each owner holds term policies on the other two through an insurance LLC in which all three are members, with coverage reviewed annually against the formula. Uninsured amounts are payable over five years at the applicable federal rate plus 2%, secured by a pledge of the purchased units, subordinated to the senior lender, with covenants capping distributions and owner compensation while the note is outstanding.

Maintenance. The formula exhibit and insurance certificates are reviewed at the annual meeting, and the minutes record the review.

That agreement is perhaps fifteen pages. It answers who buys, when, at what price, how disagreements resolve, and where the money comes from. Nothing in it is exotic, and it would have prevented every dispute described at the beginning of this article.

Primary authority

Buy-sell disputes are contract disputes until the IRS arrives, at which point they become valuation disputes. Both bodies of law matter.

  • 26 U.S.C. § 2703 and Treas. Reg. § 25.2703-1 — a buy-sell price is disregarded for estate tax purposes unless it is a bona fide business arrangement, is not a device to transfer value to family for less than full consideration, and has terms comparable to an arm's-length arrangement.
  • Revenue Ruling 59-60 — still the foundational statement of the factors in valuing closely held stock, sixty-plus years on.
  • Rev. Rul. 93-12 — minority discounts survive intra-family transfers.
  • Connelly v. United States, 602 U.S. 257 (2024) — life insurance proceeds funding a redemption obligation increase the company's value for estate tax purposes and are not offset by the redemption obligation. This decision changed how entity-purchase structures should be drafted and funded.
  • Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005) — the contrary circuit authority Connelly rejected, useful for understanding why so many older agreements are now mis-designed.
  • 26 U.S.C. § 302 and § 318 — whether a redemption is a sale or a dividend, and the attribution rules that defeat the obvious answer in family companies.
  • 26 U.S.C. § 101(a) — the income tax exclusion for life insurance proceeds, and the transfer-for-value trap that can destroy it when policies are shuffled between owners.
  • Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981) (en banc) — the willing-buyer, willing-seller standard applied to a fractional interest.
  • 26 U.S.C. § 2704 — lapsing rights and restrictions in family entities.

Related articles

This article is provided for general informational purposes and does not constitute legal advice. Buy-sell agreements involve state corporate law, contract law, insurance, and federal tax rules that change and that apply differently to each entity type and family situation. Consult qualified corporate and tax counsel before drafting, funding, or amending an agreement.