Contributed by: Austin Manning, CFP®
Business owners who have invested years of effort into building successful enterprises eventually face a difficult but essential question: what happens to the business when an owner departs, retires, or passes away? The answer often lies in a well-crafted buy-sell agreement. These agreements establish a clear plan for the transfer of ownership and can prevent disputes, protect business continuity, and ensure financial stability for both the company and the departing owner’s family.
Yet not all buy-sell agreements are structured the same. The choice between an entity redemption, cross purchase, or insurance LLC arrangement can have significant implications for tax efficiency, cost, administration, and fairness among owners. Understanding the distinctions is critical for business owners who want to protect both their legacy and their partners.
The Foundation: Why Buy-Sell Agreements Matter
Without a buy-sell agreement, businesses risk uncertainty when an ownership change occurs. Surviving owners may be forced to negotiate with heirs who lack business experience, or worse, a forced liquidation could erode years of value creation. Properly funded buy-sell agreements provide clarity by:
- Establishing a prearranged method of transferring ownership.
- Providing liquidity to purchase the departing owner’s interest.
- Protecting the company and remaining owners from financial strain.
- Offering peace of mind to families of owners, who can receive fair value.
Life insurance often plays a central role in funding these agreements, providing immediate liquidity at the precise moment it is most needed.
Entity Redemption: Simplicity With Limitations
In an entity redemption arrangement, the company itself purchases life insurance policies on each owner. When an owner passes away, the business uses the death benefit to redeem the deceased owner’s shares.
Advantages:
- Simple to administer, since the business owns and pays for the policies.
- Provides equal treatment for owners, as the company handles the redemption.
- Premiums are often lower because the business may qualify for better rates than individual owners.
Challenges:
- Surviving owners do not receive a step-up in basis for the redeemed shares, which can increase their eventual capital gains tax burden.
- In businesses with uneven ownership stakes, the arrangement may not reflect the true economic impact on each surviving owner.
- Concentrates insurance costs within the business, which can complicate financial reporting.
Entity redemption is often attractive for businesses with multiple owners seeking simplicity, but it may fall short for those focused on tax efficiency and fairness.
Cross-Purchase: Tax Efficiency at a Cost
In a cross-purchase agreement, each owner purchases life insurance policies on every other owner. Upon an owner’s death, the surviving owners use the policy proceeds to buy out the deceased owner’s shares directly.
Advantages:
- Surviving owners receive a step-up in basis on the shares they purchase, reducing future capital gains exposure.
- Aligns ownership costs and benefits with the surviving owners, since each funds their share of the buyout.
- Keeps the transaction outside the business entity, reducing administrative entanglements.
Challenges:
- Complex to administer with more than two or three owners, as the number of policies multiplies quickly.
- Premium costs can vary widely if owners differ significantly in age or health, creating inequities.
- Requires coordination and discipline among owners to ensure policies remain in force.
For closely held businesses with just two or three partners, a cross-purchase arrangement often makes the most sense, as the tax advantages outweigh the administrative burden.
Insurance LLC: A Hybrid Solution
An increasingly common alternative is to establish a separate insurance LLC (or trust) that owns and manages the life insurance policies for all owners. The LLC members are the business owners themselves, and it functions as a central mechanism for handling premiums, ownership, and proceeds.
Advantages:
- Simplifies administration by consolidating policies into one entity, rather than scattering them among multiple owners.
- Maintains the tax advantages of a cross purchase agreement, including basis step-up for surviving owners.
- Allows premium costs to be shared equitably among owners, regardless of individual age or health.
- Provides flexibility to address changes in ownership, succession planning, or buyout formulas.
Challenges:
- Requires careful legal and tax structuring to avoid unintended consequences.
- Involves additional setup and maintenance compared to a straightforward entity redemption.
- Demands disciplined governance to ensure the LLC operates according to the agreement.
For larger ownership groups or businesses seeking both efficiency and fairness, the insurance LLC model often represents the most balanced solution.
Choosing the Right Structure
The decision between entity redemption, cross purchase, and insurance LLC structures is not one-size-fits-all. Several factors should guide the analysis:
- Number of Owners: A business with two owners may prefer cross purchase, while a company with six may find it unworkable without an insurance LLC.
- Relative Ages and Health: Wide disparities can make direct cross purchase arrangements inequitable, pushing toward an LLC.
- Tax Considerations: Owners concerned with lessening future capital gains may lean toward cross purchase or insurance LLC solutions.
- Administrative Capacity: Simpler structures may be appealing when resources for governance are limited.
Ultimately, the right solution balances simplicity, fairness, tax efficiency, and long-term continuity for the business.
The Granite Harbor Perspective
At Granite Harbor Advisors, we often remind clients that a buy-sell agreement is not just a legal contract—it is a promise to protect both the business and the families connected to it. The technical structure matters, but so does the ability of the agreement to function as intended under stress. That requires careful coordination among legal, tax, and insurance professionals, as well as an advisor team committed to looking beyond the surface.
Our role is to help business owners think through these complex trade-offs with clarity and foresight. Whether the best path is entity redemption, cross purchase, or an insurance LLC, we ensure the strategy is tailored to the unique dynamics of the ownership group and the legacy they wish to protect.
Conclusion
Business continuity is too important to leave to chance. The right buy-sell agreement can preserve harmony among owners, protect families, and safeguard the value of years of hard work. The choice between entity redemption, cross purchase, and insurance LLC structures is not about theory but about finding the structure that reflects both the financial realities and human priorities of the business. With experienced guidance and thoughtful planning, owners can turn uncertainty into stability and confidence for the future.