Buy-sell agreements are not tax deductible. Whether you fund one with life insurance premiums, disability buyout coverage, or cash set aside in a reserve, the IRS treats the money as a capital outlay rather than an ordinary business expense. The consolation is meaningful: life insurance proceeds paid out under the agreement usually arrive tax-free. And the deduction question is only a small piece of the tax picture. The structure you pick, and a handful of technical rules most owners have never heard of, will decide whether the buyout goes smoothly or produces a tax bill that dwarfs anything a premium deduction could have saved.
Why Premiums Are Not Deductible
Life insurance is the most common funding tool, and IRC Section 264 flatly denies a deduction for premiums on any life insurance policy when the taxpayer is directly or indirectly a beneficiary.1Office of the Law Revision Counsel. 26 U.S. Code 264 – Certain Amounts Paid in Connection With Insurance Contracts In a buy-sell arrangement, the payer is always the beneficiary. In an entity redemption, the company pays and the company collects. In a cross-purchase, individual owners pay premiums on policies covering their co-owners. Either way, no deduction.
The Treasury regulation reinforces the point: premiums stay non-deductible even if they would otherwise qualify as ordinary trade or business expenses, so long as the taxpayer is a beneficiary.2eCFR. 26 CFR 1.264-1 – Premiums on Life Insurance Taken Out in a Trade or Business
What you get in exchange is Section 101. Death benefit proceeds are excluded from gross income whether paid to an individual, a corporation, a partnership, or an estate.3Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits26 CFR 1.101-1 – Exclusion From Gross Income of Proceeds of Life Insurance Contracts Payable by Reason of Death A business paying $15,000 a year in non-deductible premiums may collect a $2 million tax-free death benefit when the agreement triggers. For most owners, that math works even without a deduction.
Cash Reserves and Disability Buyout Coverage
Not every agreement runs on life insurance. Some businesses use sinking funds, retained earnings, or disability buyout policies. None of these create a current deduction either.
Money moved into a reserve account earmarked for a future buyout is a movement of capital on the balance sheet, not an operating expense. For S-corporations and partnerships the point is especially clear: owners already pay tax on the entity’s income through their Schedule K-1 whether profits are distributed or retained.4Internal Revenue Service. Instructions for Schedule K-1 (Form 1120-S) Shifting after-tax dollars into a savings account doesn’t produce a second deduction.
Disability buyout insurance follows the same non-deductible pattern when the business or co-owners are the beneficiaries. There is a tradeoff worth knowing. If the owner personally pays premiums with after-tax dollars, the eventual benefit is generally tax-free. If the company pays and deducts the premiums as a business expense, the benefit becomes taxable income to the recipient. Most advisors choose the non-deductible route, because the payout is usually a large lump sum where the tax hit on the benefit would be worse than the lost deduction.
Where the Bigger Tax Question Lives: Structure
The choice between a cross-purchase and an entity redemption doesn’t change deductibility, but it produces a dramatic difference in the surviving owners’ tax basis. That difference can dwarf any premium-deductibility question in dollar terms.
Cross-Purchase Agreements
In a cross-purchase, the surviving owners buy the departing owner’s interest directly. A property’s basis equals its cost, so each buyer adds the purchase price to their existing basis in the company.5Office of the Law Revision Counsel. 26 USC 1012 – Basis of Property; Cost If you held a 50% interest with a $200,000 basis and paid $800,000 for your deceased co-owner’s half, your basis in the now-100% ownership becomes $1 million.
Sell the business later for $2 million and your taxable gain is $1 million rather than $1.8 million. At a 20% capital gains rate, that’s $160,000 in federal tax saved. Funding the purchase with tax-free insurance proceeds does not reduce the basis adjustment. You get the full cost basis regardless of where the cash came from.
Entity Redemption Agreements
In an entity redemption, the company itself buys back the departing interest. The business spends its own money, often tax-free insurance proceeds, and the surviving owners’ percentage of the company rises automatically. Their personal basis does not change.
Same numbers, different result. You keep your original $200,000 basis, but now own 100% of a $2 million company. Sell for $2 million and your taxable gain is $1.8 million. That’s $160,000 more in federal capital gains tax than the cross-purchase path, and the gap widens as the business appreciates before your exit.
Entity redemptions have administrative appeal. A cross-purchase among five owners requires twenty separate policies. But the basis penalty is real and permanent, and it is the leading reason tax advisors resist entity redemptions for smaller ownership groups.
The Transfer-for-Value Trap
One rule can quietly strip away the tax-free treatment of the death benefit and turn a clean buyout into a taxable event. Under IRC Section 101(a)(2), if a life insurance policy or any interest in one is transferred for valuable consideration, the exclusion is limited to what the transferee paid for the policy plus any subsequent premiums. Everything above that becomes ordinary income.6Office of the Law Revision Counsel. 26 U.S. Code 101 – Certain Death Benefits
The scenario shows up more often than owners expect. Cross-purchase agreements sometimes require owners to swap existing policies. When three owners become two after a buyout, remaining owners may need to move policies among themselves. Even a nominal exchange can trigger the rule.
Five statutory exceptions exist:6Office of the Law Revision Counsel. 26 U.S. Code 101 – Certain Death Benefits
- Transfer to the insured.
- Transfer to a partner of the insured.
- Transfer to a partnership in which the insured is a partner.
- Transfer to a corporation in which the insured is a shareholder or officer.
- Carryover-basis transfers, such as those in certain tax-free reorganizations.
The partner exception is why many advisors run cross-purchase agreements through a partnership or an LLC taxed as a partnership. Policy transfers among partners fall within the safe harbor. Corporate shareholders in a pure cross-purchase do not get the same protection unless the transfer runs to the corporation itself. Getting this wrong can cost hundreds of thousands in unexpected tax on proceeds everyone assumed were tax-free.
Locking In the Estate Tax Value
A well-drafted buy-sell agreement can fix the value of a business interest for federal estate tax purposes, blocking the IRS from substituting a higher valuation and inflating the estate tax bill. The agreement will only be respected if it satisfies all three requirements of IRC Section 2703:7Office of the Law Revision Counsel. 26 U.S. Code 2703 – Certain Rights and Restrictions Disregarded
- It must be a bona fide business arrangement, such as one preserving continuity of management or keeping ownership out of outsiders’ hands.
- It must not be a device to transfer property to family members for less than full value.
- Its terms must be comparable to what unrelated parties would negotiate at arm’s length.
The agreement must also restrict lifetime transfers and obligate the estate to sell at the contract price. Meet all conditions and the contract price controls the estate tax value.8The Tax Adviser. Buy/Sell Agreements for S Corporations
Fixed prices set years ago are the weakest link. A number that was defensible at signing can become obviously stale as the business grows. Formulas tied to a multiple of earnings or book value hold up better, and requiring a fresh independent appraisal at each triggering event holds up best. Whichever method the agreement uses, the valuation terms need to be reviewed and actually updated. The IRS has no difficulty rejecting a price that hasn’t been touched in a decade.
Tax at the Moment the Agreement Triggers
When a triggering event forces a sale, the departing owner or their estate has a capital gain or loss equal to the sale price minus adjusted basis. The gain is long-term capital gain, taxed federally at 0%, 15%, or 20% depending on total taxable income.9Internal Revenue Service. Topic No. 409 Capital Gains and Losses
On top of that, sellers with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly) owe an additional 3.8% net investment income tax on the gain.10Internal Revenue Service. Topic No. 559 Net Investment Income Tax The combined federal top rate reaches 23.8% before state tax. This surtax is easy to overlook and can add tens of thousands to a high-value buyout.
The insurance proceeds’ tax-free status benefits only the recipient of the payout, not the seller. If a company collects a $2 million death benefit and pays $2 million to the estate for the deceased owner’s interest, the company recognizes no income on the insurance, but the estate still calculates gain or loss on the $2 million sale price. At death, the estate’s basis in the interest generally steps up to fair market value, which often eliminates most of the capital gain. Lifetime triggers like disability or retirement do not receive a step-up, so living buyouts usually generate a larger tax hit.
When insurance or cash doesn’t fully cover the price, the buyer may issue a promissory note for the balance. This can qualify for installment sale treatment under IRC Section 453, letting the seller recognize gain as payments are received rather than all in one year.11Office of the Law Revision Counsel. 26 U.S. Code 453 – Installment Method On a large buyout, installment reporting can keep the seller out of the highest brackets.
Two Traps Specific to Corporations
Dividend Recharacterization in Family Businesses
Entity redemptions in family-owned corporations run into IRC Section 302, which decides whether a redemption is taxed as a sale (capital gain) or a dividend distribution (potentially ordinary income).12Office of the Law Revision Counsel. 26 U.S. Code 302 – Distributions in Redemption of Stock Section 318’s constructive ownership rules attribute stock among family members. If a parent’s shares are redeemed but a child still owns stock, the parent is treated as constructively owning the child’s shares, the redemption may fail to qualify as a complete termination, and the whole payment can be taxed as a dividend.
A waiver of family attribution is available, but the departing shareholder must give up every interest in the corporation other than as a creditor for at least ten years, including any role as officer, director, or employee. For a parent transitioning out to a child this is often workable, but the requirement has to be built into the agreement from the start.
Protecting the S-Corporation Election
S-corporations can have only one class of stock.13Office of the Law Revision Counsel. 26 U.S. Code 1361 – S Corporation Defined A poorly drafted agreement can accidentally create a second class and blow the S election, converting the company to a C-corporation.
The most common risk is an installment-paid entity redemption. The corporation issues a promissory note to the departing shareholder, and the IRS can recharacterize the debt as equity if the terms don’t look like real debt. To stay in the safe harbor, the note should qualify as straight debt under Section 1361(c)(5): a fixed sum payable on a specified date, an interest rate not contingent on profits, and no convertibility into stock. Setting the rate at or above the applicable federal rate avoids imputed-interest problems.8The Tax Adviser. Buy/Sell Agreements for S Corporations Differences in voting rights alone don’t violate the one-class rule, but differences in distribution or liquidation rights do.