# What Are Buy Sell Agreements? Published: 2025-12-09 Author: Warren Team URL: https://www.heywarren.com/blog/buy-sell-agreements --- Nearly 70% of family-owned businesses never survive to the second generation — and one of the most preventable reasons is a missing legal document that could have been drafted in an afternoon. Most business partners assume a handshake understanding or a vague clause in their operating agreement is enough to handle the unexpected. It is not. When a co-owner dies, becomes disabled, divorces, or simply wants out, the resulting chaos can destroy a company that took decades to build. Buy sell agreements exist specifically to prevent that chaos. In this guide, you will learn exactly what a buy-sell agreement is, how it works, which type fits your business structure, and how to fund it so it actually performs when you need it most. You will also learn the most expensive mistakes owners make — and how to avoid them. According to the Exit Planning Institute, fewer than 30% of small business owners have a formal succession plan in place, leaving the vast majority exposed to a preventable crisis. This guide closes that gap. --- ## What Are Buy Sell Agreements? A buy-sell agreement is a legally binding contract between business co-owners that dictates what happens to an owner's share of the company when a triggering event occurs — such as death, disability, retirement, divorce, or bankruptcy. It sets the terms, price, and process for transferring ownership before a crisis forces an improvised solution. ![The three main buy-sell agreement structures and how ownership transfer is handled in each.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20600%20211%22%20width%3D%22600%22%20height%3D%22211%22%20role%3D%22img%22%3E%3Ctitle%3EHierarchy%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Crect%20x%3D%22220%22%20y%3D%2220%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22%232563eb%22%2F%3E%3Ctext%20x%3D%22300%22%20y%3D%2254%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22white%22%3EBuy-Sell%20Agreement%3C%2Ftext%3E%3Cpath%20d%3D%22M%20300%2078%20L%20300%20105.5%20L%20120%20105.5%20L%20120%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%2240%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22120%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ECross-Purchase%3C%2Ftext%3E%3Ctext%20x%3D%22120%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3EOwners%20buy%20each%20other%3C%2Ftext%3E%3Cpath%20d%3D%22M%20300%2078%20L%20300%20105.5%20L%20300%20105.5%20L%20300%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22220%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22300%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EEntity-Purchase%3C%2Ftext%3E%3Ctext%20x%3D%22300%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3ECompany%20buys%20shares%3C%2Ftext%3E%3Cpath%20d%3D%22M%20300%2078%20L%20300%20105.5%20L%20480%20105.5%20L%20480%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22400%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22480%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EWait-and-See%3C%2Ftext%3E%3Ctext%20x%3D%22480%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3EHybrid%20flexibility%3C%2Ftext%3E%3C%2Fsvg%3E) *The three main buy-sell agreement structures and how ownership transfer is handled in each.* Think of it as a business prenuptial agreement. Just as a prenup protects both spouses by establishing financial rules before a marriage, a buy-sell agreement protects all co-owners and the business itself by establishing ownership transfer rules before something goes wrong. The contract names the eligible buyers — either the remaining owners, the business entity itself, or both — defines the triggering events, and specifies how the buyout price will be calculated. Most importantly, it creates an obligation, not just an option, to buy or sell under those conditions. ### Cross-Purchase Agreements In a **cross-purchase agreement**, the remaining co-owners agree to buy out the departing owner's interest directly. Each owner purchases a life insurance policy on every other owner to fund a potential buyout. In a three-partner business, for example, each partner holds policies on the other two. Cross-purchase agreements typically produce a favorable **stepped-up cost basis** for the purchasing partners, which can reduce capital gains taxes if they later sell their shares. However, they become administratively complex when there are more than three or four partners, since the number of required insurance policies grows exponentially — a four-partner firm needs twelve separate policies. ### Entity-Purchase (Redemption) Agreements In an **entity-purchase agreement**, also called a redemption agreement, the business itself buys back the departing owner's shares using company funds or a policy the entity owns. The company holds a single insurance policy on each owner, which simplifies administration considerably. The tradeoff: purchasing partners do not receive a stepped-up basis in the redeemed interest. This can create a larger tax [liability](/blog/examples-liabilities) when they eventually sell their stakes. For C-corporations, there is also the potential for the **corporate alternative minimum tax** (AMT) to apply to life insurance proceeds held by the entity, depending on company size. ### Wait-and-See Agreements A **wait-and-see agreement** is a hybrid that offers maximum flexibility. When a triggering event occurs, the business has the first right to purchase the shares. If the company declines or only partially exercises that right, the remaining owners step in to buy the rest on a cross-purchase basis. This structure lets all parties assess the financial situation before committing to one approach. It is particularly useful when the business's cash flow is unpredictable or when the owners want to preserve the option to optimize for tax treatment at the time of the actual buyout. --- ## Why Every Business Partnership Needs a Succession Plan Without a formal business succession plan, the default rules of your state's laws — or the vague terms of a boilerplate operating agreement — control what happens to ownership. Those defaults are rarely what you actually want. A well-drafted buy-sell agreement creates a ready market for an otherwise [illiquid](/blog/illiquid) asset, establishes a fair price that all sides have already agreed to, and prevents the business from grinding to a halt during a transition. It converts an uncertain, emotional negotiation into a predictable, contractual process. ### Protecting Against Unexpected Death or Disability If a co-owner dies without a buy-sell agreement in place, their ownership stake typically passes to their heirs — often a spouse, adult child, or estate executor. That heir now has a legal claim on business profits and decisions, even if they have no knowledge of or interest in the business. The surviving partners cannot force a buyout without a contract that requires one. Negotiations conducted under grief, time pressure, and legal uncertainty can drag on for months and cost hundreds of thousands of dollars in legal fees. Some businesses close entirely. **Disability** is an even more statistically likely trigger than death. The [Social Security Administration](https://www.ssa.gov/) reports that more than one in four 20-year-olds will experience a disabling condition before reaching retirement age. A partner who is partially or fully incapacitated creates an immediate operational and financial question: do they retain ownership? Do they still receive distributions? Who performs their duties in the meantime? ### Preventing Unwanted Third-Party Ownership Divorce is another trigger that can introduce a stranger into the ownership structure. A family court could award a co-owner's spouse a portion of the business as a marital asset. Suddenly the remaining partners have a new, involuntary co-owner who may have every legal right to inspect financial records, demand distributions, and block major business decisions. A well-drafted agreement typically includes a **divorce trigger clause**: if a court awards any business interest to a co-owner's spouse, the remaining owners or the entity have the right — or obligation — to buy that interest at a pre-agreed formula price. This mechanism keeps ownership within the intended group regardless of what happens in an owner's personal life. --- ## How Business Buyout Agreements Are Funded A buy-sell agreement is only as effective as the money behind it. A contract obligating someone to pay $2 million for a business interest is worthless if the buyer does not have $2 million. Funding is where many business owners cut corners — and where the agreement collapses at the worst possible moment. ![How life insurance proceeds move from insurer to buyer to fund a partner buyout at a triggering event.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20875%20125%22%20width%3D%22875%22%20height%3D%22125%22%20role%3D%22img%22%3E%3Ctitle%3EFlow%20diagram%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Crect%20x%3D%2230%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22115%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ETriggering%20Event%3C%2Ftext%3E%3Ctext%20x%3D%22115%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3EDeath%20or%20disability%3C%2Ftext%3E%3Cline%20x1%3D%22205%22%20y1%3D%2262.5%22%20x2%3D%22237%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22244%2C62.5%20235%2C57.5%20235%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22245%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22330%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EInsurer%20Pays%3C%2Ftext%3E%3Ctext%20x%3D%22330%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3ETax-free%20proceeds%3C%2Ftext%3E%3Cline%20x1%3D%22420%22%20y1%3D%2262.5%22%20x2%3D%22452%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22459%2C62.5%20450%2C57.5%20450%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22460%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22545%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EBuyer%20Receives%3C%2Ftext%3E%3Ctext%20x%3D%22545%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3EOwner%20or%20entity%3C%2Ftext%3E%3Cline%20x1%3D%22635%22%20y1%3D%2262.5%22%20x2%3D%22667%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22674%2C62.5%20665%2C57.5%20665%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22675%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22760%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EBuyout%20Funded%3C%2Ftext%3E%3Ctext%20x%3D%22760%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3EShares%20transferred%3C%2Ftext%3E%3C%2Fsvg%3E) *How life insurance proceeds move from insurer to buyer to fund a partner buyout at a triggering event.* ### Life Insurance Funding **Life insurance** is the most common and often the most cost-effective funding mechanism. The death benefit arrives income-tax-free under IRC Section 101(a), precisely when it is needed, and in exactly the amount specified. Term life insurance is less expensive upfront but expires after a set period. **Permanent life insurance** — whole life or universal life — builds cash value and covers the owner indefinitely, which matters for businesses without a defined endpoint. A $1 million permanent life policy on a healthy 40-year-old business owner typically costs between $1,500 and $4,000 per year depending on policy design and insurer. That premium is a fraction of what a contentious, unplanned ownership dispute would cost in legal fees alone. ### Disability Buyout Insurance Life insurance only covers death. **Disability buyout insurance (DBO)** is a separate product that funds the buyout when a co-owner becomes permanently disabled and can no longer work. Without DBO, a business may be contractually obligated to buy out a disabled partner with no money set aside to execute the purchase. DBO policies typically have a 12- to 24-month elimination period before benefits activate, designed to confirm the disability is permanent rather than temporary. Benefits pay as a lump sum or in structured installments equal to the agreed purchase price. Coverage typically runs 60 to 70 cents per dollar of benefit per month. ### Installment Payments and Sinking Funds Some businesses fund buyouts through a **sinking fund** — a dedicated savings account the company contributes to on a regular schedule. Others rely on **installment payment arrangements**, where the departing owner or their estate receives payments over 5 to 10 years from ongoing business cash flow. Installment plans preserve immediate liquidity but introduce risk. If the business declines after the buyout, the departing owner may not collect the full agreed amount. Most attorneys recommend insurance as the primary funding mechanism and installments only as a supplemental layer. --- ## Valuing a Business for a Partner Buyout The most common point of failure in buy-sell agreements is not the legal language — it is an outdated or unrealistic valuation. If the formula no longer reflects current business value, the agreement creates the very conflict it was designed to prevent. Common valuation methods included in business partner buyout contracts: - **Fixed price**: Partners agree on a specific dollar amount at signing and are supposed to update it annually. In practice, updates are frequently skipped, leaving a stale number that bears no relationship to current business value. - **Formula method**: A mathematical calculation based on a multiple of earnings — for example, 5× [EBITDA](/blog/calculating-ebitda) or 1.5× gross revenue — or on book value. The formula updates automatically with the financial data but may not capture intangible value like brand [equity](/blog/equity-meaning-in-business), customer relationships, or proprietary technology. - **Agreed appraisal**: Each side hires its own independent appraiser. If the two valuations differ by more than a set threshold (commonly 10 to 15%), a third neutral appraiser is selected and their number binds both parties. This method is the most accurate but the slowest and most expensive. - **Single independent appraisal**: A neutral third party values the business at the time of the triggering event. Clear and objective, but the timing of the appraisal can disadvantage one side depending on business cycles. Most attorneys and CPAs recommend a **formula method with periodic mandatory reviews** — every two to three years, or whenever the business grows by more than 20%. This approach prevents extreme outcomes while keeping the process manageable. One important tax consideration: under **Treasury Regulation 25.2703**, the [IRS](https://www.irs.gov/) evaluates whether a buy-sell agreement's valuation formula is binding for estate tax purposes. An agreement that appears designed primarily to transfer business value to family members at below-market prices may be disregarded for estate valuation. The formula must reflect arm's-length, commercially reasonable terms. Work with a qualified estate attorney when drafting or updating the valuation clause. --- ## Tax Implications of Buy-Sell Agreements The tax treatment of a business ownership transfer depends on the agreement's structure, the entity type, and how the [transaction](/blog/what-is-a-transactions) is characterized by both parties and the IRS. Getting this right upfront can save tens of thousands of dollars. ![Cross-purchase agreements give buyers a stepped-up cost basis; entity-purchase redemptions do not, increasing future capital gains exposure.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20800%20210%22%20width%3D%22800%22%20height%3D%22210%22%20role%3D%22img%22%3E%3Ctitle%3EComparison%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Ctext%20x%3D%22230%22%20y%3D%2257.5%22%20text-anchor%3D%22end%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ECross-Purchase%20%28basis%20s%E2%80%A6%3C%2Ftext%3E%3Crect%20x%3D%22240%22%20y%3D%2225%22%20width%3D%22450%22%20height%3D%2255%22%20rx%3D%226%22%20fill%3D%22%232563eb%22%2F%3E%3Ctext%20x%3D%22702%22%20y%3D%2257.5%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22%232563eb%22%3E%25100%3C%2Ftext%3E%3Ctext%20x%3D%22230%22%20y%3D%22152.5%22%20text-anchor%3D%22end%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EEntity%20Redemption%20%28no%20s%E2%80%A6%3C%2Ftext%3E%3Crect%20x%3D%22240%22%20y%3D%22120%22%20width%3D%226%22%20height%3D%2255%22%20rx%3D%226%22%20fill%3D%22%237c3aed%22%2F%3E%3Ctext%20x%3D%22258%22%20y%3D%22152.5%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22%237c3aed%22%3E%250%3C%2Ftext%3E%3C%2Fsvg%3E) *Cross-purchase agreements give buyers a stepped-up cost basis; entity-purchase redemptions do not, increasing future capital gains exposure.* For the **selling owner or their estate**, proceeds from a buyout may be treated as capital gain, ordinary income, or a combination — depending on whether the payment is allocated to the underlying business assets, personal goodwill, covenant-not-to-compete, or the entity interest itself. A clear purchase price allocation written into the agreement controls how both parties report the transaction on their tax returns and reduces the risk of an IRS challenge. For the **buying owners**, a cross-purchase structure produces a stepped-up cost basis equal to the amount paid, which reduces capital gains exposure on a future sale. An entity-purchase redemption does not provide surviving owners with a direct basis increase — the redeemed shares are simply cancelled — which can produce a larger taxable gain years later when the business is sold. **Life insurance proceeds** received by an individual owner in a cross-purchase structure are generally income-tax-free. If a corporation receives the proceeds, they are excluded from regular corporate income tax but may trigger tax consequences under specific circumstances. The 2022 Inflation Reduction Act reinstated a 15% corporate alternative minimum tax on corporations with adjusted financial statement income exceeding $1 billion — a threshold that typically affects large, closely held businesses rather than small firms, but worth confirming with a tax advisor. The bottom line: always engage a CPA and a business attorney before finalizing the structure of any ownership transfer agreement. The professional fees — often $3,000 to $10,000 for proper setup — are a small fraction of the tax savings available with the right approach. --- ## Authoritative Sources For deeper background and primary-source data on this topic, the following authoritative sources are useful starting points: - [SEC](https://www.sec.gov/) - [Federal Reserve](https://www.federalreserve.gov/) - [Consumer Financial Protection Bureau](https://www.consumerfinance.gov/) - [U.S. Department of the Treasury](https://home.treasury.gov/) ## Conclusion Buy sell agreements are one of the most powerful and most neglected tools in a business owner's financial planning toolkit. Here are the key takeaways: - **A buy-sell agreement is a binding contract** that governs ownership transfers when a triggering event — death, disability, divorce, retirement, or bankruptcy — occurs. - **Three main structures** exist: cross-purchase (owners buy each other out), entity-purchase or redemption (the company buys out the departing owner), and wait-and-see hybrid agreements. Each carries different tax consequences that must be evaluated before signing. - **Funding is not optional.** Life insurance, disability buyout insurance, and sinking funds ensure the agreement can actually perform when triggered. An unfunded agreement is a legal promise backed by nothing. - **Valuations must stay current.** Reviewing the price formula every two to three years — and whenever the business grows by 20% or more — keeps the agreement aligned with reality. - **Tax treatment varies significantly** based on structure, entity type, and purchase price allocation. Professional guidance upfront prevents costly surprises during an already difficult transition. Revisiting buy sell agreements on a regular schedule is not just legal housekeeping — it is the foundation of a real exit strategy that protects every owner, every family, and the business itself. Ready to put this knowledge to work? Try Warren, your AI financial advisor — get personalized, conflict-free guidance at heywarren.com