If you own a closely held business with one or more partners, there is a document that determines what happens to your share of the business if you die, become disabled, get divorced, or want out. That document is your buy-sell agreement, and there is a meaningful chance it was drafted years ago, hasn't been touched since, and contains terms that no longer match how the business or your family actually look today. There is also a meaningful chance — particularly if it's an entity redemption agreement funded by company-owned life insurance — that a 2024 Supreme Court decision called Connelly v. United States quietly turned it into a document that could cost your family hundreds of thousands of dollars in unexpected estate taxes.
This article is a long one because the topic earns it. A buy-sell agreement is one of the most consequential planning documents a business owner ever signs, and yet it gets less attention than almost any other piece of the financial plan. We're going to walk through what these agreements actually do, the structures worth understanding, what Connellychanged and why it matters, the alternatives worth considering, and then — because Connelly is only the most famous way these agreements backfire — a longer look at the other failure modes that show up in real businesses every year.
The goal is not to tell you which structure to pick. That depends on your business, your partners, your family, your overall estate plan, and a half-dozen other variables that no article can resolve for you. The goal is to make sure you understand what's in your existing agreement well enough to ask the right questions when you sit down with the people who can resolve it. For Texas business owners in particular — where we work with families across San Antonio, Austin, Dallas, Houston, and the broader Hill Country — the absence of a state estate tax doesn't eliminate the federal exposure that Connellysharpened, and the structural issues we'll cover here matter regardless of where you live.
What a Buy-Sell Agreement Actually Does
At its simplest, a buy-sell agreement is a contract among the owners of a closely held business that answers a single question: when one owner exits — by death, disability, retirement, divorce, bankruptcy, or simply wanting out — what happens to that owner's interest in the business?
A well-drafted agreement specifies several things at once. It identifies the events that trigger a buyout (called “triggering events”). It establishes how the price will be determined — whether by a fixed formula, an annual valuation certificate, a third-party appraisal, or some combination. It specifies who has the right or obligation to buy: the company itself, the remaining owners, or both. And it describes how the purchase will be funded, which for death triggers usually means life insurance on the owners.
Without a buy-sell agreement, the death of a co-owner can create immediate chaos. The deceased owner's spouse or children may inherit the business interest with no obligation to sell and no idea how to run the business — while the surviving owners suddenly find themselves in partnership with the deceased's family, possibly forever. The business may have to be liquidated to satisfy estate tax obligations because there's no built-in source of cash to buy out the deceased owner's interest. Disputes can drag on for years.
A good buy-sell agreement prevents all of this by pre-arranging the answer. The trigger fires, the valuation method is applied, the funding mechanism activates, and ownership transitions cleanly. Done well, it preserves the business, provides liquidity to the deceased owner's family, and avoids litigation.
The “done well” part, however, depends heavily on which structure you choose, how the agreement is drafted, and whether it's been kept current as the business and the owners' lives have changed. A surprising number of agreements fail at least one of those three tests.
The Two Main Structures
There are several variations, but two basic structures account for the vast majority of buy-sell agreements: entity redemption (also called stock redemption) and cross-purchase. Each has its own logic, its own tax treatment, and — as Connellymade abundantly clear — its own ways of going wrong. A third structure, the wait-and-seeor hybrid buy-sell, blends the two and has become meaningfully more relevant since 2024; we'll cover it after the Connelly discussion, because its appeal is hard to appreciate without understanding what Connelly did to entity redemption.
Entity Redemption
In an entity redemption agreement, the business itself buys back the deceased or departing owner's interest. The company typically owns life insurance policies on each owner. When an owner dies, the company collects the death benefit and uses it to redeem the deceased owner's shares from the estate, retiring those shares as treasury stock. The surviving owners' percentages automatically increase as a result, even though they didn't write a personal check.
Entity redemption is the more popular structure for two reasons. First, it's administratively simple: with five owners, there are five life insurance policies, all owned by the same entity, with one set of premium payments to track. Second, it doesn't require the surviving owners to come up with cash personally — the funding is institutional. For closely held businesses where the partners are not flush with personal liquidity, that's a meaningful comfort.
But entity redemption has structural disadvantages that have become significantly more painful after Connelly. The surviving owners don't get a step-up in basis on the redeemed shares. So when those owners later sell the business, they pay capital gains tax on a much larger gain than they would under a cross-purchase. As we'll see, this is more than a footnote — it can easily run into hundreds of thousands of dollars on a future sale. And, post-Connelly, the life insurance proceeds now have to be counted in the company's value for federal estate tax purposes, which can dramatically increase the deceased owner's estate tax bill.
There's also a less obvious dynamic that gets called the “tontine effect” in some of the academic literature. In a redemption-funded buy-sell with no estate tax planning around it, the last surviving owner ends up with 100% of a company whose balance sheet has been temporarily inflated by life insurance proceeds — and the earlier-departing owners' families do not share in that benefit. We'll come back to this.
Cross-Purchase
In a cross-purchase agreement, the individual owners buy each other out directly. Each owner takes out a life insurance policy on every other owner. When an owner dies, the surviving owners collect the death benefits on their policies and use that cash to buy the deceased owner's shares from the estate.
The tax treatment is generally more favorable. The surviving owners get a basis step-up equal to the purchase price they paid — meaning when they later sell their interests, they pay capital gains only on the appreciation that occurs after the cross-purchase, not on the entire history of the business. The life insurance is owned outside the business, so the proceeds don't inflate the company's value for estate tax purposes. And the proceeds are typically received income-tax-free by the surviving owners.
The administrative downside is real, though. The number of policies grows quickly with the number of owners — calculated as N × (N−1), where N is the number of owners. Two owners need 2 policies. Three owners need 6. Five owners need 20. Ten owners need 90. Premium administration becomes a logistical headache, and equalizing the cost burden among owners with different ages and health profiles gets complicated fast.
A wide age disparity creates additional problems. A 35-year-old owner pays much lower premiums to insure a 60-year-old partner than the 60-year-old pays to insure the 35-year-old. Without careful drafting and equalization mechanisms, the younger owner can end up bearing a disproportionate share of the funding cost.
A Quick Tax Comparison
The basis-step-up difference between the two structures isn't theoretical. Consider a simple example with two equal partners, A and B, who each invested $100,000 in a business now worth $1,000,000.
Under an entity redemption: A dies. The company uses life insurance to redeem A's shares for $500,000. Those shares become treasury stock. B now owns 100% of the company, but B's basis is still B's original $100,000 investment. If B later sells the company for $1,000,000, the capital gain is $900,000.
Under a cross-purchase: A dies. B uses life insurance proceeds to buy A's shares directly for $500,000. B's new basis is $600,000 — the original $100,000 plus the $500,000 just paid. If B later sells the company for $1,000,000, the capital gain is $400,000.
Same end result in terms of who ends up owning the company. Vastly different tax bill on the eventual sale. At a 23.8% federal long-term capital gains rate (20% capital gains plus 3.8% net investment income tax for income above the $250,000 MFJ threshold), the tax savings under a cross-purchase in this example is roughly $119,000.
That's before Connelly enters the picture.
What Connelly Actually Decided
The Connellycase involved two brothers, Michael and Thomas Connelly, who owned a building supply company called Crown C Supply. Michael owned about 77% of the company; Thomas owned about 23%. They had an entity redemption buy-sell agreement: if either brother died, the surviving brother had the option to buy the deceased brother's shares, and if he declined, the company itself was required to redeem the shares. The company owned life insurance policies on each brother to fund the redemption — $3.5 million on each.
When Michael died in 2013, Thomas declined to buy the shares personally, so Crown C used $3 million of the $3.5 million life insurance death benefit to redeem Michael's shares from his estate. Michael's estate filed an estate tax return reporting his shares as worth $3 million — the redemption price.
The IRS disagreed. It argued that on the date of Michael's death, the company owned a $3 million asset (the life insurance proceeds about to be paid) that hadn't been there before. So Crown C was now worth $6.86 million ($3.86 million in operating value plus $3 million in life insurance proceeds), not $3.86 million. Michael's 77% share of $6.86 million was approximately $5.3 million, not $3 million. The estate tax deficiency came to roughly $890,000.
The estate's defense rested on a 2005 Eleventh Circuit case called Estate of Blount, which had ruled exactly the opposite way: that a corporation's contractual obligation to redeem a deceased shareholder's stock offsets the value of the life insurance proceeds, so the proceeds shouldn't be counted in valuing the company. For nearly two decades, Blount was the working assumption for many advisors structuring entity redemption agreements.
In June 2024, the Supreme Court unanimously rejected that reasoning. Writing for the Court, Justice Thomas reasoned that a stock redemption obligation is fundamentally different from an ordinary corporate liability like wages or rent. When a corporation receives life insurance proceeds and then uses them to redeem a shareholder's stock, the redemption shrinks the company by exactly the amount paid out — but it doesn't reduce the company's pre-redemption value, which is what matters for estate tax purposes. As the Court put it: a hypothetical buyer of Crown C, valuing the company on the date of Michael's death, would treat the incoming life insurance proceeds as a corporate asset. The redemption obligation didn't change that.
The result: life insurance proceeds payable to a corporation under a redemption-funded buy-sell agreement are now firmly included in the company's date-of-death value for federal estate tax purposes. The redemption obligation does not offset them. The deceased owner's estate pays tax on a higher value than the redemption price the family actually receives.
Why This Matters Even More Than the Tax Bill
The estate tax consequences alone are enough to justify a serious review of any redemption-funded buy-sell. But the more subtle problem is who bears the cost.
Return to the Connellyfacts. Before Michael's death, the business was worth $3.86 million. Michael's 77% interest was worth roughly $2.98 million; Thomas's 23% interest was worth roughly $880,000. Under the agreement, the company collected $3.5 million in life insurance and used $3 million of it to redeem Michael's shares. Michael's estate received $3 million (which was then taxed against a $5.3 million valuation, not a $3 million one).
Now look at Thomas's position the day after the redemption was completed. The operating business was still worth $3.86 million. The unspent $500,000 of life insurance proceeds was sitting on the company's books as cash. Thomas owned 100% of all of it. His position had moved from roughly $880,000 to roughly $4.36 million — a roughly $3.5 million gain — without him writing a personal check or paying income tax on the receipt. Michael's heirs, meanwhile, received the $3 million contractual redemption price and paid estate tax as if they had received $5.3 million.
This is the dynamic the academic literature has called the “tontine effect” — and it's worth understanding. A tontine is an old financial arrangement in which a group of people pool money, and the last surviving member takes the entire pool. Redemption-funded buy-sell agreements, when they're not paired with offsetting estate planning, function similarly: the last surviving owner ends up with all the equity, including the indirect benefit of every dollar of life insurance the company ever bought on the other owners' lives, while each deceased owner's family receives only the contractually fixed redemption price (which after Connelly is now also taxed against an inflated valuation).
For two brothers with shared interests in keeping the business in the family, this might not have felt like a problem. For non-related business partners, it can be a substantial wealth transfer that nobody intended. And for any family with a meaningful gap between the redemption price and the post-Connellyestate tax valuation, it's a real out-of-pocket cost imposed on the family of the first owner to die.
Who Should Care
Two practical thresholds matter for thinking about whether Connelly changes anything for you.
The first is whether the deceased owner's estate is likely to owe federal estate tax at all. Under OBBBA (the One Big Beautiful Bill Act, signed July 4, 2025), the federal estate and gift tax exemption for 2026 is $15 million per person, or $30 million per married couple, with the top estate tax rate at 40%. The exemption is now indexed for inflation going forward. For owners well below those numbers, Connellymay not produce an actual federal tax bill — though the basis and “tontine” issues still matter. For owners with combined estates approaching or exceeding the exemption, the inclusion of life insurance proceeds in business valuation can drive estate tax liability up significantly.
Note one important caveat for owners outside Texas. Texas has no state estate tax, which simplifies the analysis for clients here. But roughly a dozen states do impose their own estate or inheritance taxes, often at exemption levels far below the federal threshold — Massachusetts and Oregon, for example, start at $1 million and $1 million respectively, and Washington's top rate now exceeds 20%. If you own a closely held business and have a partner or co-owner who resides in a state with its own estate tax, the Connelly inclusion may produce a state-level tax bill even where no federal tax is owed. Cross-state buy-sells deserve their own conversation.
The second threshold is the size of the life insurance policies relative to the business value. The bigger the policy compared to the company, the bigger the Connellyimpact. A small policy on a large company barely moves the valuation needle. A large policy on a small or mid-sized company can swing valuation dramatically — in Connelly's case, the $3 million policy nearly doubled the company's date-of-death value.
If you're a closely held business owner with a redemption-funded buy-sell, life insurance on your life owned by the company, and an estate that approaches the federal exemption (or where state estate taxes apply), this case applies to you directly. If any of those pieces are absent, the basis-step-up and tontine issues may still be reasons to revisit the structure — they were already arguments for a cross-purchase before Connelly sharpened the estate tax case.
The Cross-Purchase Alternative — and Its Own Wrinkles
If a cross-purchase agreement avoids the Connelly problem and produces a better basis result, why doesn't everyone use one? Because cross-purchase comes with its own complications.
Policy proliferation. As discussed, the math gets ugly fast. A business with five owners needs 20 separate policies, each with its own premium, beneficiary, and administrative footprint. That alone pushes many businesses into the simpler entity redemption structure.
Transfer-for-value risk. This is the technical trap that catches a lot of people. Under IRC §101(a)(2), if a life insurance policy is transferred for valuable consideration to certain parties, the income-tax-free treatment of the death benefit is lost. There are exceptions — transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer — but they're narrowly defined.
This matters because if an owner dies and their estate ends up holding policies on the surviving owners (which then get sold or transferred to those surviving owners), the transfer can trip the rule and turn a tax-free death benefit into taxable income at the next death. Drafting around this requires real care.
Cash-value inclusion in the estate. With each owner personally owning policies on the other owners' lives, the cash value of those policies is included in the policy owner's taxable estate. For owners with permanent (cash-value) life insurance, this can create unanticipated estate tax consequences on a separate dimension — the policies you own on your partners aren't free of estate tax just because they're insurance.
Premium funding inequities. As mentioned, age disparities create unequal premium burdens, which usually need to be addressed through bonus arrangements, equalization clauses, or other mechanisms to keep things fair. None of these is fatal. They're solvable problems, but they need to be solved deliberately, with documents that match the strategy.
The Insurance LLC: A Hybrid Worth Knowing About
For businesses with three or more owners — where the policy proliferation problem of a pure cross-purchase becomes unmanageable — there's a hybrid structure that has gotten increased attention since Connelly: a special-purpose insurance LLC.
The structure works like this. The owners form a separate limited liability company, taxed as a partnership, whose only function is to own and administer the life insurance policies that fund the buy-sell agreement. Each owner is a member of the insurance LLC in roughly the same proportion as their ownership of the operating company. The insurance LLC owns a single life insurance policy on each owner — five owners, five policies, instead of the 20 policies a pure cross-purchase would require.
When an owner dies, the LLC collects the death benefit and allocates it among the surviving members. Those members then use the cash to buy the deceased owner's shares of the operating company under the cross-purchase agreement. The surviving owners get a basis step-up just like in a normal cross-purchase. The insurance proceeds never sit on the operating company's books, so they don't inflate its value for estate tax purposes.
The reason this works without triggering transfer-for-value problems is the partnership exception in IRC §101(a)(2): transfers of policies to a partnership in which the insured is a partner are excluded from the rule. As long as the LLC is a real partnership for tax purposes, with a legitimate business purpose, the death benefits remain income-tax-free.
That last point is where the IRS has signaled it intends to scrutinize these arrangements. In a 2007 private letter ruling, the IRS approved a partnership formed solely to fund a buy-sell agreement. But the IRS has since taken a no-ruling position on the structure, meaning new requests for advance approval won't be answered. After Connelly drove up demand for insurance LLCs as a workaround, observers have warned that the IRS is likely to look harder at LLCs whose only apparent purpose is tax avoidance, particularly those without real economic substance beyond holding policies.
The practical implication: if you're considering an insurance LLC, the structure needs to be genuine — real ownership shares, real partnership operation, real business purpose, real adherence to the partnership tax rules — not a paper entity that holds policies and does nothing else. This is not a do-it-yourself project.
The Wait-and-See Buy-Sell: Flexibility for an Uncertain Tax Landscape
There's a third structure worth understanding, especially given the post-Connelly environment: the wait-and-see buy-sell, sometimes called a hybrid buy-sell.
The idea is to defer the decision about which structure to use — entity redemption or cross-purchase — until the moment a triggering event actually occurs. The agreement is drafted so that, on death or another triggering event, the company has a first option to redeem the deceased owner's shares within some specified window (often 60 to 90 days). If the company declines or only partially exercises its option, the surviving owners then have a second option to buy the remaining shares as a cross-purchase. If neither the company nor the owners step up, the agreement typically requires one of them — usually the company — to complete the purchase as a fallback so that the deceased owner's family is not left holding shares with no liquidity.
The appeal of this structure is genuine flexibility. At the moment of the triggering event, the parties can look at the company's actual financial condition, the owners' personal cash positions, the deceased owner's estate situation, the then-current tax law, and the state of the buy-sell's funding, and choose the path that produces the best outcome. If the company has the cash and the deceased owner's estate is well below the federal exemption, a redemption may be simpler and faster. If the surviving owners need basis step-up because they intend to sell the company in the foreseeable future, a cross-purchase produces the better long-term result.
But wait-and-see has real complications, and Connellychanges them. First, the funding question is harder. If the company owns the life insurance policies but the parties elect a cross-purchase at the triggering event, the cash has to get from the company to the surviving owners somehow — usually as a dividend (taxable in a C corporation) or distribution (with its own pass-through tax consequences), each of which creates friction. Some agreements address this by having the company own the policies on the operatingcompany side and using a separate insurance LLC for cross-purchase-style funding, but that's two structures running in parallel and the drafting burden grows quickly.
Second, even a wait-and-see agreement does not escape Connellyif the company-owned policy structure ends up funding a company redemption. The Supreme Court's reasoning applies based on what actually happens at the date of death, not what could have happened. So if the wait-and-see process plays out as a redemption funded by company-owned life insurance, the Connellyvaluation issue is back in the picture — the structure has only provided an option to avoid that outcome, not a guarantee.
Third, wait-and-see agreements require careful coordination between the buy-sell, the operating agreement or shareholder agreement, and any related insurance trust arrangements. The “election” mechanism — who decides, by what vote, by when, with what notice — needs to be airtight, or the structure becomes a litigation invitation.
For closely held businesses with three or more owners, meaningful estate tax exposure on at least one owner, and a long enough planning horizon to think about a future sale, a wait-and-see agreement combined with an insurance LLC is one of the cleaner answers to the post-Connelly environment. For two-owner businesses, the additional complexity often isn't worth it; a straightforward cross-purchase usually wins.
Converting an Existing Redemption Agreement to a Cross-Purchase
For owners with a redemption agreement that no longer makes sense after Connelly, the natural question is: how do we change it? The mechanics are not as simple as redrafting the contract. The harder question is what to do with the life insurance policies that the company already owns.
Three main paths exist, each with trade-offs. A note before walking through them: in all three paths, the firststep — getting policies out of the company and into the hands of the insured individuals — is generally protected by the transfer-to-insured exception under §101(a)(2). The transfer-for-value risk shows up at the second step, when the insureds then need to get those policies into the hands of the otherowners (since under a cross-purchase, each owner holds policies on the other owners' lives, not on themselves). Whichever path you take to step one, step two needs its own deliberate solution.
Path 1: Distribute the policies from the company to the owners. The operating company transfers each policy to the insured owner — A's policy goes to A, B's to B, and so on — and then each owner transfers their own policy to the other owners under a new cross-purchase agreement. The trouble at step one is that distribution of a corporate-owned policy to a shareholder is presumptively a taxable event: either a dividend (in a C corporation) or a deemed distribution that may flow through under partnership rules. The fair market value of a life insurance policy is generally the “interpolated terminal reserve” plus unearned premiums, with further guidance in Revenue Procedure 2005-25. For a permanent policy with substantial cash value, the tax bill on distribution can be meaningful. The trouble at step two is that the subsequent transfer to the other owners is the transfer-for-value step described above, and unless the recipients are partners of the insured in a real partnership, the death benefit on the transferred policy can become taxable.
Path 2: Sell the policies from the company to the owners. Instead of distributing the policies at no consideration, each owner buys their ownpolicy back from the company at fair market value. The company has a taxable gain to the extent the sale price exceeds basis (typically minimal in the early years of a policy, but meaningful for older policies with substantial cash value), and the owners use after-tax personal dollars to make the purchase. This avoids the dividend characterization of Path 1 at step one, but step two — getting each policy into the hands of the other owners — has the same transfer-for-value issue as Path 1 and needs the same kind of solution.
Path 3: Transfer the policies into an insurance LLC. The company distributes (or sells) each policy to the insured owner; the owners then contribute their policies to a newly-formed insurance LLC taxed as a partnership. This route uses the partnership exception under §101(a)(2)(B) to take the transfer-for-value risk off the table at step two, and lands the structure in a place that mirrors the hybrid we described above. It's more complex up front but often produces the cleanest long-term result, particularly for businesses with three or more owners.
In all three paths, the underlying buy-sell agreement also has to be rewritten — the new agreement must be a genuine cross-purchase (or insurance-LLC-funded equivalent), not a redemption agreement with a label change. And in all three paths, the existing policies' insurability and pricing matter: policies issued years ago at younger ages and better health may be much cheaper than equivalent new coverage would be today, which is one reason owners often want to preserve the existing policies rather than start over.
This is exactly the kind of decision that needs coordinated input from the company's tax advisor, an estate planning attorney, an experienced insurance specialist, and a financial planner who can model the long-range outcomes under each path. The decision is genuinely complex, and the wrong choice can be more expensive than no change at all.
The Other Ways Buy-Sell Agreements Backfire
Connellyis the most famous recent example of a buy-sell agreement going wrong, but it's not the only way these documents fail. In our experience working with Texas business owners across San Antonio, Austin, Dallas, Houston, and the Hill Country — and in the broader literature — several patterns show up regularly. If you're already pulling the agreement out for a Connelly review, these are worth checking at the same time.
Vague or Stale Valuation Language
The single most common defect in buy-sell agreements is bad valuation language. Agreements that call for “fair value” without defining it, or “book value” without specifying which book and which adjustments, or “agreed-upon value” with no mechanism to keep the agreement current, are agreements that produce litigation when triggered.
A common arrangement is for owners to set an agreed value annually by signing a certificate of agreed value, with a fallback to appraisal if the certificate hasn't been updated within some period — usually a year or two. The fallback exists because in practice, certificates of agreed value are notoriously neglected. Owners sign them in the first year, then never get around to it again, and the company doubles or triples in value over the next decade while the certificate quietly goes stale. By the time a triggering event occurs, the certificate is hopelessly outdated and the agreement may not specify what to do about it.
Even appraisal-based agreements have failure modes. They may not specify who pays for the appraisal, what discounts (for lack of marketability, lack of control, minority interest) the appraiser is allowed or required to apply, or what happens if the surviving owners and the deceased owner's estate disagree with the result. Each of these omissions is a litigation invitation.
Missing Terms for Predictable Events
Buy-sell agreements drafted for a small partnership tend to focus on the death of an owner. As the business grows, the original agreement often fails to anticipate other triggering events that become increasingly likely.
A non-exhaustive list of terms commonly missing or underdeveloped in older agreements: rules for admitting new owners, mandatory retirement provisions, notice periods for voluntary departures, phased-retirement options, treatment of disability (with a precise definition of “disability”), divorce provisions specifying what happens if a court awards an ownership interest to a non-owner spouse, treatment of personal bankruptcy of an owner, dispute resolution mechanisms, non-compete and client-transition rules, and provisions for the disposition of business-owned real estate (which often becomes a contested asset on its own).
Each of these is an event that has a non-trivial probability over the life of a multi-owner business. If the agreement doesn't address them, the default is whatever state law provides, which is rarely what the owners would have chosen.
Failure to Update
This is almost a category unto itself. A buy-sell signed when the business was worth $500,000 may simply not work when the business is worth $5 million. Life insurance policies sized for the original valuation are inadequate for the current one. Ownership percentages may have shifted through subsequent transactions. The agreement may name people who are no longer owners and fail to bind people who are.
Consider a fact pattern that reappears in different forms: a closely held company is owned by three partners. The agreement, drafted 15 years ago, gives surviving partners the right to buy a deceased partner's stock at a formula price, with the proceeds going to the deceased partner's estate. The agreement specifically names each shareholder and their estate as parties bound by the agreement.
Five years ago, one partner transferred their shares to a living trust as part of a divorce settlement. The trust names that partner as trustee during their lifetime and the partner's ex-spouse as successor trustee. The trust provides that on the partner's death, the shares are to be divided between the partner's two adult children.
When that partner dies, the ex-spouse — now the successor trustee — argues that the living trust is not bound by the buy-sell agreement, since neither the trust nor the partner's probate estate were parties to the original agreement. The shares pass to the children, who are estranged from their father and their uncles and want the business liquidated. The surviving partners argue the buy-sell prevents this. Litigation is the likely result.
This kind of scenario happens because buy-sell agreements are signed once and then forgotten while the people, entities, and ownership structures around them keep changing. A periodic review — every two or three years, or whenever a major life event occurs for any owner — is the only reliable defense.
Failure to Follow the Terms You Wrote
Even an agreement with strong terms can be effectively voided by repeated non-compliance. If your buy-sell requires a majority vote to admit new owners, but new owners have been admitted three times in the past decade without taking a vote, a court may decline to enforce the voting requirement when you finally try to invoke it. The pattern of practice can override the written agreement.
This is not unique to buy-sell agreements — it's a general principle of contract law — but it shows up here often because the documents are signed and then not closely consulted for years at a time.
Using the Agreement to Oppress Minority Owners
Buy-sell agreements can also be misused by majority owners to entrench themselves and pressure minority owners. Common patterns include refusing to redeem a minority owner's interest while simultaneously preventing the minority owner from selling to outside buyers (using rights of first refusal as a blocking mechanism rather than a transfer mechanism), withholding discretionary distributions or bonuses to deny the minority owner liquidity, or setting the buy-out price at a punitively low formula value.
Some of this is handled at the entity-formation stage with supermajority voting requirements and protected-class provisions. Some of it is handled in the buy-sell agreement itself, with provisions ensuring symmetry between rights to buy and obligations to sell. But none of it is handled well by an agreement that's been on autopilot for ten years.
If you're a minority owner in a closely held business, your buy-sell agreement is one of the few documents that can protect you when your interests diverge from the majority's. If the agreement was drafted by counsel chosen by the majority owner, it's worth having your own attorney review it.
Tax Surprises Beyond Connelly
Several other tax dynamics can produce unintended results when a buy-sell triggers.
Different basis among owners. Original founders often have very low basis in their shares. Later investors who bought in at higher valuations have much higher basis. When a triggering event produces a sale, the founders pay much more capital gains tax than the recent investors on identical proceeds. The agreement may not address this asymmetry.
Inside-outside basis differences in pass-through entities. In partnerships and S corporations, the difference between an owner's basis in their ownership interest (outside basis) and their share of the entity's basis in its assets (inside basis) can produce unexpected results for departing owners. The underlying entity-selection decision shapes how all of this plays out — our S-Corp vs LLC walkthrough covers the trade-offs that drive these differences. A Section 754 election can address the inside-outside gap in partnerships, but it's a deliberate planning step, not an automatic feature.
Section 6166 estate tax deferral. Owners with closely held businesses often plan to use IRC §6166, which allows estate tax on a closely held business interest to be paid in installments over up to 14 years. The provision requires the closely held business to comprise at least 35% of the adjusted gross estate. A buy-sell that triggers a quick sale of the business interest can inadvertently disqualify the estate from this relief, accelerating the estate tax bill at the worst possible moment.
Net Investment Income Tax (NIIT). Installment payments from a buy-sell may push the recipient's modified adjusted gross income above the $250,000 (MFJ) or $200,000 (single) NIIT threshold, adding a 3.8% tax to investment income. The agreement may not contemplate this when setting payment schedules.
IRC §2703 and family-business valuation. When a buy-sell agreement is among family members, IRC §2703 imposes additional requirements before the agreement's valuation will be respected for estate tax purposes. The arrangement must be a bona fide business arrangement, not a device to transfer property to family members below fair market value, and the terms must be comparable to similar arrangements between unrelated parties at arm's length. Family-owned business buy-sells that don't satisfy these tests will have their valuations disregarded by the IRS, and the actual fair market value will be used instead. This is one of several intersections between buy-sell planning and the broader estate planning toolkit — wills, trusts, beneficiary designations, and ILITs — that the family should be reviewing alongside the business documents.
ESOPs as an alternative exit path. Although it isn't a buy-sell in the traditional sense, an Employee Stock Ownership Plan (ESOP) is worth knowing about. An ESOP is a qualified retirement plan that owns shares of the sponsoring employer, and it can be used as a structured liquidity event — the owner sells some or all of their shares to the plan, the plan finances the purchase, and over time the shares are allocated to employees as part of their retirement benefits. It's a fundamentally different structure with its own tax and operational complexity, but for some closely held businesses without a clear successor, it can replace or supplement a traditional buy-sell. The decision involves a substantial valuation, plan administration, and ongoing fiduciary obligations, and it deserves its own conversation.
None of these issues is exotic. They show up in real business successions every year. The pattern across all of them is the same: buy-sell agreements interact with the rest of the tax code in ways that aren't obvious from the four corners of the document, and those interactions are easy to miss without an integrated review.
What an Integrated Review Looks Like
If you've made it this far and you're now wondering whether your own buy-sell needs a closer look, here's roughly what a thorough review covers.
First, the structure. Is it an entity redemption, a cross-purchase, a wait-and-see hybrid, or something else? Is the structure still appropriate given the post-Connelly landscape, the current value of the business, the ownership composition, and the owners' personal estate situations? If life insurance is involved, who owns the policies, what type of insurance is it, and what are the cash values?
Second, the valuation language. How is the price set? When was it last updated? What happens if the parties disagree? Does it satisfy IRC §2703 if family members are involved? Are appropriate marketability and minority discounts addressed?
Third, the triggering events. Does the agreement cover death, disability, retirement, voluntary withdrawal, divorce, bankruptcy, and termination of employment? Are the definitions precise enough to avoid disputes? Are there cases where the agreement is silent and state-law defaults will apply?
Fourth, the funding. Is the life insurance still adequate to cover the current valuation? Are policies on owners over 70 still in force and economical? Has the cost-sharing among owners kept pace with their changing ages and percentages?
Fifth, the estate planning interface. Will the agreement disrupt or support each owner's individual estate plan? Are there §6166 considerations? Are there ILIT (irrevocable life insurance trust) opportunities that haven't been considered? How does the agreement coordinate with each owner's revocable living trust, if any? For owners with co-owners in states with their own estate taxes, has anyone modeled the state-level exposure?
Sixth, the documentation. Have actual practices matched the written agreement? Have all transfers been properly documented? Are the parties bound by the agreement still the parties who actually own the business? Are amendments and addenda all signed and consistent?
Owners actively planning toward a sale should overlay this review on the broader timeline laid out in our 5-year business exit planning guide — the buy-sell review is one of the first items that belongs on a thoughtful exit timeline, not the last.
This is not a one-meeting project, and it's not the kind of thing that gets resolved with a form-document update. It requires coordinated input from your business attorney, your estate planning attorney, your tax advisor, your insurance specialist, and a financial planner who can hold all of those moving pieces in view at once.
A Final Thought
The most common misconception about buy-sell agreements is that they are static documents — sign once, file away, hope you never need them. They are nothing of the sort. They are living instruments that need to evolve as your business grows, as your partners change, as your family situation changes, as tax law changes, and as Supreme Court rulings change the meaning of the words you signed years ago. A buy-sell agreement that worked perfectly for the business as it existed at signing may be actively dangerous for the business as it exists today.
The good news is that buy-sell agreements are contracts, and contracts can be amended. The owners can sit down with their advisors, look at the current document, identify what's stale or broken or simply wrong, and rewrite the parts that need rewriting. The harder part — the part that often doesn't happen — is just deciding to do it.
If you're a business owner who hasn't reviewed your buy-sell agreement in the last three years, that's the part to start with. Pull the document out. Read what it actually says, not what you remember it saying. Ask whether it would still produce the result you want if a triggering event occurred next month. If the answer is anything other than a confident yes, the next conversation is one you should put on the calendar.
Common Questions
Does Connelly affect my buy-sell if my company doesn't own life insurance on me?
Connellyspecifically addressed the inclusion of life insurance proceeds in business valuation when those proceeds are payable to a corporation under a redemption-funded buy-sell. If your company does not own life insurance on its owners and your buy-sell is funded some other way — personal life insurance held by individual owners, sinking funds, seller financing, third-party financing, or a hybrid — Connelly itself does not apply directly. That said, the broader principles the Court articulated about how to value closely held businesses still matter, and the structural issues we discussed (basis step-up, tontine effect, drafting failures) are all reasons to revisit any older agreement regardless of funding mechanism.
What's the difference between an entity redemption and a stock redemption?
These terms are generally used interchangeably. “Stock redemption” is the older terminology, used when buy-sells were most commonly structured for corporations issuing stock. “Entity redemption” is the broader term that captures the same concept across corporations, LLCs, and partnerships — the entity(whatever it's called) buys back the departing owner's interest. The mechanics are the same: the business itself acquires the departing owner's stake, often funded by life insurance the business owns. Connelly's reasoning applies to both labels.
Can a wait-and-see buy-sell solve the Connelly problem?
Only partially, and only if the parties actually elect a cross-purchase or insurance-LLC-funded transaction at the triggering event. The Supreme Court's reasoning in Connelly applies based on what actually happens at the date of death, not what could have happened. A wait-and-see structure provides the option to avoid the Connellyoutcome — but if the option ends up being exercised as a redemption funded by company-owned life insurance, the same inclusion problem reappears. Wait-and-see is most useful when paired with funding that doesn't rely on company-owned insurance for the redemption path, or with an offsetting estate plan that contemplates the tontine effect.
Does Connelly apply to S corporations and LLCs, or only C corporations?
The Connellydecision involved a C corporation, but the underlying valuation principle — that life insurance proceeds payable to a business entity under a redemption-funded buy-sell are included in the entity's date-of-death value — applies regardless of entity type. S corporations and LLCs structured to redeem a deceased owner's interest using entity-owned life insurance face the same fundamental issue. The collateral tax consequences differ across entity types (pass-through treatment of distributions, basis adjustments, S-corp distribution rules), but the estate tax exposure is comparable.
How often should we update our buy-sell agreement?
A useful baseline is to review the agreement every two to three years, even if no changes are needed, and to revisit it any time one of the following occurs: a significant change in business valuation, a change in ownership composition (new owner, departing owner, transfer to a trust), a major life event for any owner (marriage, divorce, birth of children, death of a spouse), a change in entity structure, or a material change in tax law. Connellyitself qualifies as a material change in tax law for many businesses; the federal estate exemption changes under OBBBA do too. If your agreement hasn't been touched in five or more years, treat it as overdue regardless of what else has happened.
What happens to a buy-sell agreement in a divorce?
This depends entirely on what the agreement says. Well-drafted agreements include divorce as a triggering event, with provisions specifying what happens if a divorce court awards some or all of an owner's interest to a non-owner spouse. Common approaches include: an automatic right of first refusal allowing the company or other owners to buy the interest before it transfers to the ex-spouse, a mandatory buyout funded under the existing valuation mechanism, or restrictions on the ex-spouse's voting and economic rights. Agreements that do not address divorce often produce litigation, because state-law default rules vary widely and may not align with the owners' intentions. If your buy-sell is silent on divorce, that omission is one of the most common and consequential gaps we see.