Open the buy-sell agreement and find the policy disposition clause before you move a single contract. Most well-drafted agreements give the departing owner a defined window — commonly thirty to ninety days after closing — to purchase the policy insuring their own life, usually at cash surrender value or at interpolated terminal reserve plus unearned premium. That window is the deadline that governs. Miss it and the option typically lapses, leaving the company holding a policy on a person who no longer has any connection to the business.
The second thing to establish, before anyone signs a transfer form, is who currently owns each policy and who is named as beneficiary. Buy-sell insurance is frequently misfiled: agreements drafted as cross-purchase arrangements funded with policies the entity actually owns, or vice versa. A mismatch between the agreement and the policy registrations is common, it is fixable while everyone is still cooperative, and it becomes very difficult to fix once the departing owner has moved on.
In This Article
Which Structure Was It, Really?
Two designs dominate, and the disposition analysis is different for each.
Cross-purchase. Each owner personally owns a policy on each other owner and is the beneficiary. On a death, the survivors receive proceeds individually and use them to buy the decedent’s interest. The advantage is a stepped-up basis in the purchased interest for the surviving owners. The disadvantage is arithmetic: three owners need six policies, five owners need twenty. That combinatorial problem is why many closely held businesses drift into an entity structure without redrafting the agreement.
Entity redemption (stock redemption). The company owns the policies, pays the premiums, and is the beneficiary. On a death, the company receives proceeds and redeems the decedent’s shares. Administratively far simpler. No basis step-up for the surviving owners, and — as of 2024 — a valuation consequence that did not exist before.
There are hybrids: wait-and-see agreements that defer the choice until a triggering event, and insurance LLCs or partnerships that hold policies for the owners’ benefit. The insurance-partnership design exists precisely to solve the tax trap described in the next section, and if the business already uses one, that is a meaningful advantage in a buyout. Confirm the actual ownership registration with each carrier in writing; do not assume the agreement’s description matches reality. Related fact patterns appear in buy-sell funding after a partner is bought out and what to do when a buy-sell policy is no longer needed.
The Transfer-for-Value Trap, in One Paragraph
Life insurance death benefits are generally received income-tax free under IRC § 101(a)(1). IRC § 101(a)(2) takes that away when a policy has been transferred for valuable consideration: the death benefit becomes taxable to the extent it exceeds the transferee’s consideration plus subsequent premiums. The statute then restores tax-free treatment for a short list of transfers — to the insured; to a partner of the insured; to a partnership in which the insured is a partner; to a corporation in which the insured is a shareholder or officer; and transfers where the transferee’s basis carries over from the transferor.
Read that list again and notice what is missing. A transfer to a fellow shareholder of a corporation is not on it. This is the single most common tax accident in closely held business insurance. When a corporate cross-purchase arrangement is restructured after a buyout, and the remaining shareholders buy the policies formerly held by the departing owner, the exception simply does not apply, and a seven-figure death benefit can become taxable income years later.
The workarounds exist but must be executed deliberately. A transfer to the insured is always safe. A transfer to a partnership in which the insured is a partner is safe — hence the insurance-LLC structure, where the owners are partners of one another and policy transfers among them fall inside the exception. A transfer to the corporation is safe if the insured is a shareholder or officer of that corporation. What is never safe is transferring policies between shareholders of a corporation and hoping the general rule applies. See also what changes when the owner and the insured are different people.
Connelly Changed the Redemption Math in 2024
In Connelly v. United States, decided June 6, 2024, the Supreme Court held unanimously that life insurance proceeds a corporation receives to fund an obligation to redeem a deceased shareholder’s stock increase the corporation’s fair market value for federal estate tax purposes, and that the redemption obligation is not a liability that offsets them. The Court declined to follow the contrary reasoning of the Eleventh Circuit’s 2005 decision in Estate of Blount v. Commissioner.
The practical effect: in a redemption-funded buy-sell, the decedent’s shares are valued in a company that has just received the insurance proceeds, so the estate’s share of that value goes up, and the estate tax can rise even though the family receives the same redemption price. For estates below the federal exclusion this is a planning footnote. For larger estates it is a reason many advisers are revisiting redemption structures in favor of cross-purchase or insurance-partnership designs.
Why it matters at a buyout specifically: a company deciding what to do with orphaned policies is also, implicitly, deciding what its future structure will be. If the remaining owners intend to keep funding a buy-sell, the post-Connelly analysis should drive that choice before the policies are moved — because moving them twice can itself create a transfer-for-value problem. This is a conversation for the company’s tax counsel, not for an insurance intermediary.
| Post-buyout transfer | Section 101(a)(2) exception? | Consequence if no exception applies |
|---|---|---|
| Company transfers the policy to the insured | Yes — transfer to the insured | Not applicable; treatment stays tax-free |
| One shareholder buys a policy from another shareholder | No — co-shareholder is not an enumerated exception | Death benefit taxable above consideration plus later premiums |
| One partner buys a policy from another partner | Yes — partner of the insured | Not applicable |
| Transfer to a partnership in which the insured is a partner | Yes | Not applicable |
| Transfer to a corporation where the insured is a shareholder or officer | Yes | Not applicable |
| Gift of the policy (carryover basis) | Yes — carryover-basis transfer | Not applicable; gift tax rules apply separately |
| Sale to an unrelated institutional buyer | No, but the buyer accepts that treatment | Seller reports gain; reportable policy sale reporting applies |
Two More Provisions That Bite
Premiums are never deductible. IRC § 264(a)(1) disallows a deduction for premiums paid on a policy covering an officer, employee, or any person financially interested in the business when the taxpayer is directly or indirectly a beneficiary. Businesses occasionally discover on audit that years of premium deductions were improper.
Redemption versus dividend. A corporate redemption is tested under IRC § 302 to determine whether it is treated as a sale or as a dividend distribution. The attribution rules of § 318 can treat stock held by family members as owned by the redeeming shareholder, defeating the tests and converting what everyone assumed was capital gain into ordinary dividend income. In a family business buyout, this is a live risk that has to be analyzed before closing, not after.
The corporate alternative minimum tax. The 15 percent corporate alternative minimum tax enacted in 2022 applies only to very large corporations measured by adjusted financial statement income, and life insurance proceeds reflected in book income can enter that computation. It is irrelevant to nearly every closely held business, but worth naming so nobody is surprised in a larger transaction.
Disposition Options, Ranked
- Transfer the policy to the insured. The cleanest answer in most buyouts. It is an enumerated transfer-for-value exception, it gives the departing owner coverage they may genuinely want, and it removes an asset the company no longer needs. Price it as the agreement specifies and document the consideration.
- Keep the policy if it still funds an obligation. If the remaining owners have an ongoing buy-sell obligation among themselves, or a key person exposure, or a loan covenant requiring coverage, the policy is doing work. Retitle it correctly and keep paying.
- Restructure into an insurance partnership. Where a cross-purchase is intended among corporate shareholders, holding the policies in a properly formed partnership or LLC brings future transfers within the partner exception. Set it up before moving policies, not after.
- Reduce the face amount. If the obligation shrank with the buyout, cutting the death benefit cuts the cost of insurance and the funding requirement without abandoning coverage.
- Convert to a key person policy. A policy on a remaining owner can be repurposed if the business has a genuine key person exposure. Redo the notice-and-consent documentation if the contract is employer-owned. Key person coverage after an executive retires covers the parallel case.
- Policy loan. Liquidity without ending coverage, at the cost of interest accrual and a reduced benefit.
- 1035 exchange. Reposition cash value into a contract better matched to the new structure, tax-free. Underwriting on a new contract may not be available depending on the insured’s age and health.
- Surrender. Gain above basis is ordinary income. Simple, immediate, and typically the lowest-value exit for an older insured.
- Sell the policy in the secondary market. Where the insured is older or impaired, the coverage is genuinely unwanted, and the face amount is meaningful, market value can substantially exceed surrender value. Establish basis first — see how basis is computed and how settlement proceeds are taxed — and expect reportable policy sale information reporting to apply.
When Selling Is the Wrong Answer
When the departing owner wants the coverage. Transferring the policy to the insured is an enumerated tax exception, satisfies the agreement, and often costs the company nothing beyond the contractual price. Marketing that policy to third parties instead of offering it to the person it insures is usually worse for everyone and can breach the agreement.
When a buy-sell obligation survives the buyout. If two owners remain and still owe each other a purchase obligation, the policies are collateral for that promise. Selling them leaves a funded obligation unfunded, and replacing coverage later at older ages costs far more — if it is available at all.
When a lender requires the coverage. SBA loans and many commercial credit agreements require life insurance on the principals, often with a collateral assignment recorded with the carrier. A sale cannot close over a lender’s assignment anyway, and attempting one can trip a default provision.
When the insureds are young and healthy. Secondary market pricing is a function of modeled life expectancy. Owners in their forties and fifties will draw either no bids or bids below surrender value. This is the most frequent reason a business disposition process ends with nothing.
When basis exceeds market value. A heavily funded policy can have basis approaching or exceeding what the market will pay. Surrendering may then produce a better after-tax result than selling, or the analysis may favor simply keeping the contract. Run the numbers before soliciting offers.
When the transfer would trigger § 101(a)(2) for the buyer’s benefit and nobody has checked. Any disposition among owners needs the exception analysis first. A transaction structured to be convenient can quietly convert a tax-free benefit into taxable income for the eventual recipient. Related traps appear in selling a policy to a family member.
A Closing Checklist
Documents. The buy-sell agreement and every amendment; the closing documents for the buyout; each policy’s declarations page; and a carrier-issued ownership and beneficiary verification for every contract.
Reconcile. Compare what the agreement says the ownership structure is against what the carriers actually show. Fix mismatches while the departing owner is still cooperative and still has a reason to sign forms.
Calendar. Note the deadline in the disposition clause, the next premium due date on every policy, and any no-lapse guarantee that a missed payment would forfeit permanently.
Tax analysis. For every contemplated transfer, identify which § 101(a)(2) exception applies, in writing, before the transfer. If none applies, redesign the transaction.
Consents. Employer-owned contracts issued after August 17, 2006 carry notice-and-consent requirements that cannot be cured retroactively; a restructuring is a good moment to confirm the file is complete.
Successor documentation. Update the beneficiary designations, the address of record, and the authorized contacts. Orphaned business policies lapse for the same mundane reason personal ones do: nobody was opening the mail.
If the analysis points toward disposing of a policy on an older or impaired insured, Pine Lake Life Solutions offers a free policy review — an education and eligibility screen covering policy type, in-force costs, and whether a secondary market realistically exists at that face amount and health profile. It is not an offer, carries no obligation, and is not a substitute for tax counsel. Send the policy cover page and the current statement, or call (305) 209-7183. Related dissolution scenarios are covered in policies held through a dissolving professional practice and key man coverage when a business closes.
Frequently Asked Questions
What is the deadline for dealing with a policy after a partner buyout?
The buy-sell agreement usually sets it. Most well-drafted agreements give the departing owner a defined window, commonly thirty to ninety days after closing, to purchase the policy on their own life at a stated price such as cash surrender value or interpolated terminal reserve plus unearned premium. Missing that window generally extinguishes the option and leaves the company holding an orphaned contract.
Why can’t the remaining shareholders just buy the departing owner’s policies?
Because a transfer to a fellow shareholder is not one of the transfer-for-value exceptions in IRC section 101(a)(2). The exceptions cover transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is a shareholder or officer, and carryover-basis transfers. A shareholder-to-shareholder sale can make the death benefit taxable.
How did the Connelly decision change entity redemption planning?
In June 2024 the Supreme Court held that life insurance proceeds a corporation receives to fund a stock redemption increase the corporation’s fair market value for estate tax purposes, and that the redemption obligation does not offset them. For estates above the federal exclusion this can raise the tax on the decedent’s shares, and it has pushed many advisers to revisit redemption structures.
Can the business deduct the premiums it paid on buy-sell policies?
No. IRC section 264(a)(1) disallows a deduction for premiums on a policy covering an officer, employee, or person financially interested in the business when the taxpayer is directly or indirectly a beneficiary. Businesses sometimes discover on audit that years of deductions were improper. Treat the premiums as a nondeductible cost when modeling the true expense of the arrangement.
What is an insurance LLC and why do advisers use one?
It is a partnership or limited liability company formed to hold the policies used in a cross-purchase arrangement. Because the owners are partners of one another, transfers of policies among them fall within the partner exception to the transfer-for-value rule, and the structure also solves the arithmetic problem of needing many policies. It must be formed for legitimate business purposes and properly documented.
Is there ever value in selling an orphaned buy-sell policy?
Sometimes, but only in a narrow case: the insured is older or in impaired health, the coverage genuinely serves no remaining obligation, the face amount is large enough to interest institutional buyers, and market value clearly exceeds surrender value after tax. Establish cost basis first, because a heavily funded policy can have basis approaching what the market would pay.
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Related Reading
- Buy Sell Funding Partner Bought Out
- Buy Sell Agreement Policy Unneeded
- Business Closing Key Man Policy
- Key Person Policy Executive Retired
- Policy Owner Vs Insured Different
- Professional Practice Dissolution Policy
- Selling Policy To Family Member
- Cost Basis Life Insurance Policy
- Taxes On Life Settlement Proceeds
Pine Lake Life Solutions does not purchase life insurance policies and does not provide legal, tax, or investment advice. Information provided is for educational purposes only. Eligibility for any option, including life settlements, is not guaranteed and depends on individual circumstances, policy terms, underwriting, and market conditions. Consult independent legal, tax, or financial professionals before making decisions regarding a life insurance policy.