Key Person Insurance and Buy-Sell Agreements: Funding Ownership Transfers

For an established business with multiple owners, a buy-sell agreement is only as strong as the money standing behind it, and life insurance is the most common way to guarantee that cash is there the moment an owner dies or exits. Key person and buy-sell coverage are related but distinct: one reimburses the company for losing a vital contributor, the other funds the actual purchase of a departing owner’s stake.

The distinction matters more than most owners realize, and a 2024 Supreme Court decision has made the funding structure you choose a far higher-stakes question than it was two years ago. Getting it wrong can inflate a deceased owner’s taxable estate by millions.

• Life insurance–funded buy-sell agreements rose roughly 23% in 2025 as business valuations climbed, according to advisory industry data.
• An estimated 60% of business owners still lack a properly funded succession plan, leaving their partnerships exposed.
• Partnership disputes over succession have cost an average of $184,000 in legal fees when no clear funded agreement exists.
• The 2024 Connelly v. United States ruling changed how entity-owned policies affect estate valuation, a shift every multi-owner business should review.
• Face amounts should track enterprise value, not a salary multiple, which is the calculation that trips up most do-it-yourself plans.

What Does It Mean to Fund a Buy-Sell Agreement?

A buy-sell agreement is the contract that decides what happens to an ownership interest when a triggering event occurs, but the agreement itself does not produce any money. Funding is the separate question of where the cash to complete that purchase actually comes from.

Life insurance is the most common answer because it creates a large, predictable sum exactly when it is needed, and it usually arrives income-tax-free. The alternatives all carry serious drawbacks for an established business.

• Cash reserves tie up working capital and rarely match the full value of an owner’s stake.
• Bank loans after a death are slow, expensive, and far from guaranteed during a leadership disruption.
• Installment buyouts leave the departing owner’s family exposed to the company’s future performance for years.
• Life insurance death benefits are generally received income-tax-free, making them the most efficient funding source available.
• A predetermined valuation method inside the agreement prevents disputes with the deceased owner’s estate over price.

Cross-Purchase vs. Entity-Purchase: Which Structure Fits?

The two original structures determine who owns the policies, who receives the death benefit, and how the surviving owners’ tax basis is treated. For a business with significant enterprise value, that choice affects administration, cost, and estate exposure in ways that compound over time.

Neither is universally better. The right answer depends on the number of owners, the spread in their ages and health, and the company’s structure. For context on what employees pay out of pocket, see our guides on MRI costs without insurance and chiropractor costs without insurance.

• In a cross-purchase agreement, each owner holds a policy on every other owner and buys the departing owner’s share directly.
• In an entity-purchase agreement, the business owns the policies, receives the proceeds, and redeems the departing owner’s interest.
• Cross-purchase suits a small number of owners but the policy count grows quickly, since five owners would require twenty policies.
• Entity-purchase simplifies administration to one policy per owner, which is why it is common for larger ownership groups.
• Cross-purchase generally gives surviving owners a step-up in basis on the shares they buy; entity-purchase typically does not.

How Does the Connelly Decision Affect Entity-Purchase Funding?

In 2024, the U.S. Supreme Court decided Connelly v. United States, and it reshaped the calculus for entity-owned buy-sell insurance. The Court held that when a company owns life insurance to redeem a deceased shareholder’s stock, those proceeds can be counted as a company asset when valuing the business for estate tax purposes.

The practical effect is sharp: the policy meant to fund the buyout can inflate the value of the deceased owner’s estate, without an offsetting liability for the redemption obligation. For a high-value business, that can mean a materially larger estate tax bill than the owners ever anticipated.

• The ruling applies specifically to entity-purchase, or stock-redemption, arrangements where the business owns the policy.
• It does not eliminate entity-purchase planning, but it does demand a fresh review of any existing entity-owned agreement.
• Cross-purchase structures are generally outside the issue, since the proceeds are paid to individual owners rather than the company.
• Some businesses are responding with a separate insurance LLC to hold the policies and keep proceeds off the company balance sheet.
• This is squarely a question for coordinated legal, tax, and insurance review, not a decision to make on coverage features alone.

We cover this development in depth in our analysis of the Connelly decision and 2026 buy-sell planning, and it is the single most important reason for multi-owner businesses to revisit older agreements now.

How Much Coverage Does the Agreement Need?

The face amount on buy-sell policies should equal the value of the ownership interest being purchased, which means it ties to enterprise value rather than any salary figure. This is where funding most often falls short, because valuations climb and the coverage does not keep pace.

Consider a straightforward example. Two partners own a business valued at $4 million, split evenly.

• Each partner’s interest is worth $2 million, so each buy-sell policy should be issued for roughly that amount.
• If one partner dies, the survivor receives the death benefit income-tax-free and uses it to buy the $2 million interest from the heirs.
• The family receives fair value in cash, and the surviving partner keeps full ownership without draining the business.
• As the business grows to $6 million or $8 million, the policies must be revisited or the funding gap reopens.
• Determining the right amount overlaps with broader succession needs, which we address in our guide to how much key person insurance a business needs.

Coordinating Buy-Sell With Key Person Coverage

Because both coverages use life insurance on the same individuals, owners sometimes try to make one policy serve both purposes. That shortcut usually creates conflict, because the two goals point the money in different directions.

Key person insurance reimburses the company for the operational hit of losing a vital contributor, while buy-sell funding pays the departing owner’s estate for their stake. Keeping them separate keeps each goal clean.

• A single policy cannot simultaneously fund a stock purchase and replace lost operating income without shortchanging one of them.
• Separate policies let you set the right beneficiary, owner, and amount for each distinct purpose.
• Coordinating both within one program is where a broker’s structuring work pays off, rather than buying coverage piecemeal.
• For owners who are also key contributors, both needs frequently apply at once and should be planned together.
• Our overview of key person insurance cost explains how the operational side is priced and sized.

What Triggers a Buy-Sell, Beyond Death?

Death is the event most owners plan for, but it is not the only one a well-built agreement should address. The funding question changes depending on which triggers the agreement covers, because life insurance only answers the death scenario.

An agreement that names other triggers without funding them simply moves the cash crisis to a different event. This is a gap we see often in older agreements.

• Death is the cleanest trigger to fund, since life insurance pays a defined benefit directly tied to the event.
• Disability is a common trigger that life insurance alone does not cover, and it may call for separate disability buy-out coverage.
• Retirement and voluntary exit usually require a funding plan beyond insurance, such as a financed installment buyout.
• A divorce or bankruptcy of an owner can force an unwanted party into the ownership group without a clear trigger clause.
• A “wait-and-see” structure lets owners delay choosing cross-purchase or entity-purchase until a triggering event actually happens, preserving flexibility.

Term or Permanent Life Insurance for Buy-Sell Funding?

Both term and permanent policies can fund a buy-sell agreement, and the right choice depends on the planning horizon and budget rather than a single rule. The mistake is choosing on premium alone without matching the policy to how long the need will last.

For most established businesses, the question is how permanent the ownership structure is expected to be.

• Term insurance is simpler and lower cost, fitting owners with a defined exit horizon or a tight premium budget.
• Permanent coverage fits longer-term planning and builds cash value that can serve as a sinking fund for emergencies or opportunities.
• A term policy that expires before the buyout is needed leaves the agreement unfunded at the worst possible moment.
• Permanent policies cost more up front but remove the renewal and expiration risk that term carries.
• Many owners blend the two, using term for a temporary gap and permanent coverage for the core, long-horizon need.