Two partners build a machine shop in Fresno over twenty years. One dies on a Tuesday. By Friday, the surviving partner is across the table from the deceased partner’s spouse, who now owns half the business and has opinions about how it should run. Nobody wanted this. It happens constantly, because the paperwork that was supposed to prevent it either didn’t exist or didn’t work the way everyone assumed.
A buy-sell agreement is the fix. Funded with life insurance, it does something quietly powerful. When an owner dies, cash shows up exactly when it’s needed, and the business stays with the people still showing up to work. No fire sale. No forced partnership with an heir who’s never set foot on the floor.
That’s the easy part to understand. The hard part is how you structure it, because the structure decides who pays tax later and how much.
Cross-purchase or entity redemption: pick carefully
There are two main ways to build this. In a cross-purchase agreement, each owner personally buys a policy on every other owner. Partner A owns a policy on Partner B, and the reverse. When B dies, A collects the death benefit and uses it to buy B’s share from the estate. Clean, and it carries a real tax advantage. The surviving owner gets a step-up in basis on the interest they just bought, so if they sell the business later, that higher basis means a smaller taxable gain.
The catch shows up with more than two or three owners. Four owners means twelve policies. Five owners, twenty. Premiums vary by age and health, so a younger owner ends up subsidizing an older one.
The other route is entity redemption, also called a stock redemption or entity-purchase plan. Here the business itself owns one policy per owner and buys back the deceased owner’s interest directly. Fewer policies, simpler administration, one entity writing the checks. For a California LLC or partnership with several members, the tidiness is appealing.
But the tidy option got more complicated in 2024.
What Connelly changed for entity redemption
In June 2024, the Supreme Court decided Connelly v. United States, and it landed hard on redemption-style plans. Two brothers owned a building-materials company that held life insurance to buy out whichever brother died first. When one did, the IRS and the estate disagreed about how to value his shares.
The Court ruled unanimously that the life insurance proceeds the company received counted as a corporate asset for valuing the business, and the company’s obligation to redeem the deceased owner’s shares did not offset that value. In plain terms: insurance money meant to buy out an owner made the whole company worth more on paper, which raised the value of the deceased owner’s estate and the estate tax that came with it.
For years, a lot of redemption agreements were written on the opposite assumption. If yours is one of them, it’s worth a fresh look. This doesn’t make entity redemption wrong for everyone. But it narrowed the gap that used to make redemption the obvious default, and it has pushed many advisors back toward cross-purchase structures for closely held businesses where estate tax is a live concern.
The transfer-for-value trap nobody sees coming
Life insurance death benefits are normally income-tax-free. That’s the whole appeal. But one rule can quietly strip that exemption away, and buy-sell planning walks right into it if you’re not careful.
Under the transfer-for-value rule in Section 101 of the tax code, if a policy is transferred to someone in exchange for valuable consideration, the death benefit can become taxable income to the extent it exceeds what was paid. Here’s where businesses trip. Say you started with an entity redemption plan, then decided to switch to cross-purchase, so the company hands its policies over to the individual owners. That handoff can be a transfer for value. Suddenly a death benefit that should have been fully tax-free is partly taxable.
The same risk shows up when owners sell policies to each other to rebalance an uneven cross-purchase setup. Moving policies feels like housekeeping. To the tax code, it can look like a sale.
There are exceptions, and one is genuinely useful here. A transfer to a partnership in which the insured is a partner is safe from the rule. That single carve-out is why some California businesses set up a separate insurance-only LLC, taxed as a partnership, to own all the policies. The LLC holds one policy per owner instead of a tangle of cross-owned contracts, and because every insured is a member, moving policies in doesn’t trigger the transfer-for-value problem. You get cross-purchase-style tax treatment without the twenty-policy headache. Worth knowing that the IRS won’t issue advance rulings blessing this structure, so it needs to be built carefully with a tax advisor, not copied off a template.
Where key person coverage fits
Buy-sell funding answers what happens to ownership. It doesn’t answer what happens to the business the morning after. That’s a different policy. Key person coverage is owned by the company on the life of someone it can’t easily replace, the rainmaker, the lead engineer, the founder whose name is on the door. If that person dies, the death benefit gives the business room to recruit, cover lost revenue, and reassure a nervous bank.
Plenty of California companies need both, and people routinely confuse them. One keeps ownership stable. The other keeps the lights on.
None of this is one-size-fits-all. The right structure for a two-person partnership in Sacramento looks nothing like the right one for a five-member LLC in San Diego. Basis, estate tax exposure, owner count, and how you plan to exit all pull in different directions. The mistake isn’t choosing wrong. It’s never choosing at all, then finding out the hard way that the agreement in the drawer stopped matching the business years ago.
If it’s been more than a couple of years since anyone read your buy-sell agreement out loud, that’s the signal. Start with a quote and a conversation about how your coverage is actually structured. Better to find the gap now than let your partner’s family find it for you later.