Overview: When a business owner or key employee dies, the financial consequences can be catastrophic and immediate. Business continuation planning — supported by life insurance — protects the company's operations, its ownership structure, and the financial security of all parties involved.

Why Life Insurance Is Essential

A business faces three distinct threats when a key person dies:

Operational disruption — lost revenue, client relationships, and specialized knowledge
Ownership chaos — the deceased's shares pass to heirs who may have no interest in, or knowledge of, the business
Creditor pressure — banks may call outstanding loans, suppliers may demand prepayment, and lines of credit may be frozen

Life insurance addresses all three simultaneously. It provides immediate, tax-free cash that the business can use to stabilize operations, fund a buyout of the deceased's interest, and reassure creditors. Without this cash, even a profitable, well-run business can collapse within months of losing its leader.

Entity Purchase Plans vs. Cross-Purchase Plans

When co-owners want to ensure an orderly transition of ownership, they enter into a buy-sell agreement — a legally binding contract specifying who must buy, who must sell, at what price, and under what circumstances. Life insurance funds the buyout. The critical choice is who owns the policies.

Entity Purchase Plan (Stock Redemption Plan): The business entity owns the policies, pays the premiums, and is the beneficiary. When an owner dies, the business receives the death benefit and uses it to buy back (redeem) the deceased's shares from the estate.

Cross-Purchase Plan: Each owner individually owns, pays for, and is the beneficiary of a policy on every other owner. When one owner dies, the surviving owners receive the death benefit and use it to buy the deceased's interest directly from the estate.

The key differences:

Feature	Entity Purchase	Cross-Purchase
Policy owner	The business	Individual surviving owners
Number of policies needed	N (one per owner)	N × (N–1); grows rapidly
Tax basis step-up for survivors	No	Yes — survivors' basis increases by purchase price
Creditor exposure	Policies are business assets; reachable by business creditors	Policies are personal assets; protected from business creditors
Administrative complexity	Low (one buyer, one set of policies)	High with many owners
Post-Connelly estate tax risk	High	Low

The basis step-up advantage in cross-purchase plans: This is the most important tax benefit to understand. When a surviving owner buys a deceased owner's shares at fair market value under a cross-purchase plan, the buyer's cost basis in those newly acquired shares equals the purchase price. If the business is later sold, capital gains are calculated from that higher basis — dramatically reducing the tax bill. Under an entity purchase plan, the surviving owners' percentage increases automatically (because fewer shares are outstanding), but their original cost basis stays unchanged — meaning a much larger taxable gain when they eventually sell.

The Connelly estate tax trap (2024): In Connelly v. United States, the U.S. Supreme Court ruled unanimously that when a corporation receives life insurance proceeds to redeem a deceased owner's shares, those proceeds must be counted as a corporate asset when valuing the estate. The corporation's contractual obligation to redeem the shares does not offset this asset as a liability. This inflates the value of the deceased owner's estate for estate tax purposes — sometimes dramatically. The practical result: entity purchase plans are now significantly disadvantaged for owners with taxable estates. Cross-purchase plans, or plans structured through a separate insurance-only LLC or trusteed arrangement, avoid this trap entirely.

Worked Example: Cross-Purchase Plan in a Two-Partner LLC

Facts: Partner A and Partner B each own 50% of an LLC valued at $1,000,000. Each partner's interest is worth $500,000. They establish a cross-purchase buy-sell agreement funded with life insurance.

Setup:

Partner B purchases a $500,000 life insurance policy on Partner A's life (Partner B is the owner and beneficiary)
Partner A purchases a $500,000 life insurance policy on Partner B's life (Partner A is the owner and beneficiary)

When Partner A dies:

Partner B files a claim and receives the $500,000 death benefit income-tax-free (IRC § 101(a))
Partner B pays $500,000 to Partner A's estate in exchange for Partner A's 50% LLC interest
Partner A's estate transfers the interest to Partner B
Partner A's estate receives $500,000 in cash — no capital gains tax because the estate's basis was stepped up to fair market value ($500,000) at death under IRC § 1014
Partner B now owns 100% of the LLC
Partner B's tax basis in the total LLC increases from $100,000 (original) to $600,000 ($100,000 + $500,000 new purchase price) — a significant future tax benefit

Result: The estate receives fair cash value. Partner B retains complete control. No creditors are unsatisfied. The business continues without interruption. This is the ideal outcome that a well-designed, funded buy-sell agreement is designed to achieve.

Worked Example: Entity Purchase Plan — Same LLC

Using the same two-partner LLC, now structured with an entity purchase plan:

Setup: The LLC owns a $500,000 life insurance policy on each partner.

When Partner A dies:

The LLC files a claim and receives $500,000 income-tax-free
The LLC pays $500,000 to Partner A's estate; the estate transfers the 50% interest back to the LLC
The LLC retires Partner A's membership interest
Partner B automatically owns 100% of the LLC
Partner B's cost basis in the LLC remains at $100,000 (original) — no step-up

The estate tax issue: For estate tax purposes, the IRS values the LLC at the moment of Partner A's death including the $500,000 of life insurance proceeds on the LLC's balance sheet. If the LLC had business assets worth $1,000,000 plus $500,000 in insurance proceeds, the IRS may value the company at $1,500,000 — and Partner A's 50% interest at $750,000. The estate pays taxes on $750,000 of value but only received $500,000 in cash. The Connelly ruling makes this a real and significant risk.

FAQ — Buy-Sell Plans

Q: Why does the number of policies in a cross-purchase plan grow so fast?
A: Because every owner must hold a separate policy on every other owner. With 3 owners, you need 3 × 2 = 6 policies. With 5 owners, you need 5 × 4 = 20 policies. For businesses with more than 2 or 3 owners, this becomes unwieldy — which is why a separate insurance LLC or trust is often used to hold policies centrally while still preserving the cross-purchase tax benefits.

Q: Why do the surviving owners get a tax basis step-up under cross-purchase but not entity purchase?
A: In a cross-purchase, the surviving owners are buying shares at fair market value with their own money (the insurance proceeds). Their basis equals what they paid — the purchase price. In an entity purchase, the business (not the surviving owners personally) buys and retires the shares. The surviving owners never purchase anything; their percentage simply increases because fewer shares exist. They paid nothing for those extra percentage points, so their basis doesn't increase.

Q: Does the entity purchase plan have any remaining advantages after Connelly?
A: It remains simpler to administer (fewer policies) and equalizes premium costs across partners regardless of age disparities. For businesses without significant estate tax exposure (estates below the federal exemption threshold), Connelly may not be a practical concern. The choice always requires coordination with a tax advisor.