Tax Implications of Insurance-Funded Buy-Sells: Basis, Step-Up, and Estate Considerations

High-net-worth (HNW) owner-managed businesses in the United States commonly use life insurance to fund buy-sell agreements. That approach provides liquidity at death, preserves continuity, and simplifies valuation disputes — but it also creates a web of tax consequences for the decedent’s estate, surviving owners, and the business entity. This article explains the key federal tax rules (basis and step‑up), transfer-for-value and estate-inclusion pitfalls, typical structuring choices, and practical planning steps for U.S. taxpayers in cities such as New York, San Francisco, Chicago, and Los Angeles.

Executive summary (what this article covers)

• How buy-sell funding with life insurance interacts with basis and step-up rules at death.
• Differences between cross-purchase and entity-purchase structures and their tax outcomes.
• Common estate inclusion and transfer‑for‑value traps — and how ILITs and premium financing affect tax and estate results.
• Practical examples and a comparison table to support decision-making.
• Real-world vendors and where to get indicative cost guidance.

Core tax concepts — basis at death and step‑up

• Step‑up in basis: Under federal tax law, most assets included in a decedent’s gross estate receive a new basis equal to fair market value at date of death (commonly called a “step‑up”). See IRS guidance on basis of assets for details: https://www.irs.gov/publications/p551 and the statutory rule: https://www.law.cornell.edu/uscode/text/26/1014.
• Life insurance proceeds: Life insurance death benefits are generally excluded from the beneficiary’s gross income under IRC rules (i.e., income tax free) unless an exception applies — notably the transfer‑for‑value rule or if the proceeds are included in the insured’s estate because the insured retained incidents of ownership. See general life-insurance tax guidance: https://www.investopedia.com/terms/l/lifeinsurance.asp.

Practical implications:

• If the deceased owner’s equity interest is included in the gross estate (which typically occurs if the owner still owned the shares at death), that interest is eligible for a step‑up to fair market value.
• The buyer (surviving owner or company) who acquires the interest via the buy‑sell will have a tax basis equal to the purchase price paid (generally the insurance proceeds paid to the seller/estate or to the company).

Structures and tax consequences: cross‑purchase vs entity‑purchase

The tax consequences depend heavily on the buy‑sell structure.

Cross‑purchase (co-owners buy insured's interest)

• Ownership of policies: Each owner owns policies on the other owners.
• At death: Surviving owners receive proceeds and pay the estate for the shares.
• Tax outcomes:
  • The estate receives cash for the sale of the decedent’s shares. Because the decedent’s interest is included in the gross estate, the decedent’s basis is stepped up to FMV at death — often resulting in little or no capital gain on that sale.
  • Each purchasing owner’s basis in the newly acquired shares equals the purchase price (the amount paid), not the decedent’s old basis. That becomes the buyer’s basis going forward.

Entity‑purchase (corporate redemption)

• Ownership of policies: The company owns policies on each principal and is beneficiary.
• At death: Company receives proceeds and redeems/shares from the estate.
• Tax outcomes:
  • Redemption may be taxed as a sale or treated as a dividend under Code §302/§301 tests; consequences turn on the corporate and shareholder facts (pro rata ownership changes, etc.).
  • The estate generally still benefits from any step‑up attributable to the decedent’s interest included in the estate. However, because the company (not the surviving owners) acquires or retires the shares, surviving owners do not receive a stepped-up basis in the acquired economic value unless a follow‑on transaction occurs.

Compare at a glance:

Transfer‑for‑value rule, incidents of ownership, and estate inclusion

• Transfer‑for‑value rule: If an insurer pays proceeds to a transferee who acquired the policy for value, the otherwise tax‑free death proceeds may become partially taxable. There are statutory exceptions (transfer to the insured, partner, partnership, corporation) but transfers to trusts or third parties may trigger tax if not structured correctly. See authoritative discussion: https://www.investopedia.com/terms/t/transferforvalue.asp.
• Incidents of ownership & estate inclusion: Proceeds payable to the estate or payable to a trust where the insured retained control can be included in the gross estate under IRC §2042, eliminating the income tax benefit of exclusion and preventing step‑out from estate taxation. The typical fix for HNW clients is to use an Irrevocable Life Insurance Trust (ILIT) to own policy and remove incidence of ownership; proper drafting and timing matter.

Illustrative numerical example (NYC / San Francisco HNW scenario)

Assumptions:

• Business total value: $9,000,000. Three equal owners (A, B, C) — each 33.33%, interest = $3,000,000.
• Owner A dies; life insurance policy proceeds of $3,000,000 fund the buy‑sell.

Outcomes:

• Estate of A: interest included in gross estate → basis stepped up to $3,000,000. If the estate sells the interest for $3,000,000 to B and C, the estate recognizes little or no capital gain. Net to heirs: proceeds received income tax free (subject to estate tax if large enough — see below).
• Buyers (B & C): basis in acquired shares = $3,000,000 (their cost). Their future capital gain/loss will be computed from this new basis.
• If instead the company (entity purchase) received proceeds and redeemed the shares, B & C would not automatically get a stepped-up basis in their personal holdings.

Estate tax and liquidity considerations for HNW owners

• Federal estate tax exemption (as of mid‑2024) was ~$12.92M per individual (indexed). For married couples, portability and planning can increase shelter. Because laws change, check current IRS guidance and consult counsel. See IRS estate tax portal: https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.
• Life insurance proceeds included in the gross estate can both provide liquidity for estate taxes and, if properly owned outside the estate (e.g., ILIT), provide liquidity without increasing the estate tax base.

Premium financing, costs, and vendor considerations

High face amounts typical in buy-sell funding for HNW owners often make premium financing attractive. Common players:

• Insurers offering private-client and survivorship products: New York Life, MassMutual, Northwestern Mutual, Prudential — they sell whole life, survivorship universal life, and other permanent solutions commonly used in buy‑sells for HNW clients. See each firm’s business succession pages for program details. Example vendor pages:
  • New York Life — business succession planning: https://www.newyorklife.com/business-succession-planning
  • MassMutual — business succession services: https://www.massmutual.com/insights/business-succession
• For term and online pricing benchmarks, brokers such as Policygenius publish sample premium ranges showing how age, face amount, and term affect cost: https://www.policygenius.com/life-insurance/how-much-does-life-insurance-cost/.

Indicative cost ranges (illustrative only; obtain quotes):

• A 20‑year term for a healthy 40‑year‑old might cost hundreds of dollars per year per $100k of coverage, while permanent survivorship policies for HNW protection often require premiums in the tens of thousands to hundreds of thousands of dollars annually, depending on age, face amount, and policy type. Premium financing can shift initial cash outlay to a lending arrangement; financing costs depend on lender spreads and prevailing interest rates — speak to private banks (e.g., Bank of America Private Bank) or specialty finance teams at large brokerages.

Practical planning checklist for advisors (New York / California / Illinois focus)

• Confirm whether the business interest will be included in the insured’s gross estate and whether a step‑up will occur.
• Choose structure: cross‑purchase vs entity‑purchase — analyze §302/§301 and basis consequences.
• Use an ILIT to keep insurance proceeds out of the insured’s estate (if estate exclusion is desired). Coordinate trust ownership with the buy‑sell mechanics.
• Address transfer‑for‑value risks before assigning policies or changing ownership.
• If premium financing is considered, calculate after‑tax economics using realistic loan rates and lenders' margin assumptions.
• Coordinate with valuation triggers and insurance design to ensure the policy face amount aligns with the valuation method in the agreement: see Valuation Triggers and Insurance Coverage: Aligning Policy Design with Succession Events.
• For comparative structure decisions, review Cross-Purchase vs Entity-Purchase: Which Insurance-Funded Buy-Sell Works for Your Business?.
• For funding and underwriting best practices, review Funding Buy-Sell Agreements with Life Insurance: Best Practices for Business Succession.

When to call specialists

Engage a multi-disciplinary team early:

• Estate planning attorney (ILIT drafting, estate inclusion analysis) — for clients in New York, CA, IL jurisdictions, state law differences matter for community property, spousal rights, and state estate tax.
• CPA / tax advisor (basis, step‑up, estate tax projection).
• Experienced life insurance broker or private client specialist at carriers (MassMutual, New York Life, Northwestern Mutual, Prudential) to secure underwriting-flexible products and pricing.
• If using premium financing, consult private bank lending teams and a securities/loan counsel.

Closing thought

Insurance-funded buy-sell agreements are powerful tools for preserving business continuity and providing estate liquidity for HNW owners in major U.S. markets. However, the tax outcomes hinge on careful structuring — particularly how step‑up in basis, the identity of the policy owner/beneficiary, and redemption mechanics interact. Coordinate corporate counsel, estate counsel, and experienced insurance advisers to lock in desired tax and succession results.

Further reading: Premium Financing for Buy-Sell Policies: When Leverage Enhances Succession Outcomes.