The short answer
A small business with two or three owners needs life insurance for two questions. If one owner dies, who gets their share, and where does the money come from? That is the buy-sell agreement. If the person the business cannot run without dies, how does it pay bills while it finds a replacement? That is key person cover. The two jobs need separate policies.
For policy types and comparisons, see our life insurance guides.
The two jobs life insurance does in a small business
Think of a two-owner shop: a plumbing company, a bakery, or a small agency. If one owner dies, two problems arrive on the same day, and they need two different pots of money.
The first problem is ownership. The deceased owner’s share passes to their family, who may own half a business they do not work in. A buy-sell agreement fixes that in advance: who buys the share, at what price, and how it is funded, usually with life insurance.
The second problem is operations. If the person who brings in clients or runs the crew dies, revenue drops while rent, payroll, and loan payments stay put. Key person cover is a policy the business owns on that person, with the business as beneficiary, to fund the gap while it hires a replacement.
These are separate policies. A buy-sell policy pays for the share. A key person policy pays the business so it can survive. Using one policy for both jobs leaves one job unfunded.
What a buy-sell agreement is, in plain language
A buy-sell agreement is a written contract among owners that says what happens to a share when an owner dies, retires, becomes disabled, or wants out: who can buy it, how the price is set, and how the buyer pays.
The price is usually set by a formula agreed in advance: a fixed amount reviewed yearly, a multiple of revenue or profit, or an independent appraisal. The funding is usually life insurance, because few small businesses keep enough cash to buy out a partner on short notice.
Death is the main trigger, but disability, retirement, and a voluntary exit matter too. If your agreement lives in a drawer unread for three years, fix that first.
Cross-purchase vs entity-purchase in one table
There are two main structures, and the difference is who owns the policy. In a cross-purchase agreement, each owner buys a policy on the other owner’s life. In an entity-purchase agreement, also called a redemption agreement, the business buys a policy on each owner and buys the share back. A hybrid lets the parties choose when the trigger happens.
| Feature | Cross-purchase | Entity-purchase (redemption) |
|---|---|---|
| Who owns the policy | Each surviving owner, on the other owner’s life | The business, on each owner’s life |
| Who pays the premiums | Each owner, personally | The business |
| Who receives the death benefit | The surviving owner, personally | The business |
| Who buys the share | The surviving owner, directly from the estate | The business, which redeems the share |
| Number of policies for 2 owners | 2 (one on each owner) | 2 (one on each owner, owned by the business) |
| Number of policies for 3 owners | 6 (each owner insures the other two) | 3 (one on each owner) |
| What happens to the survivor’s tax basis | Survivor’s basis in the business generally increases by the purchase price | No basis increase for the survivors in the same way |
| Connelly estate tax risk | Proceeds go to the survivor personally, so they do not inflate the company value | Proceeds go to the company, so they can inflate the company value for estate tax (see below) |
For a two-owner shop, the count is the same either way. For a three-owner shop, cross-purchase needs six policies while entity-purchase needs three. Talk to an attorney and a CPA before you choose.
The Connelly warning: what the Supreme Court actually held
In June 2024, the Supreme Court decided Connelly v. United States, 602 U.S. 257, unanimously. It is the warning every owner with an entity-purchase agreement should know.
Two brothers, Michael and Thomas Connelly, were the sole shareholders of Crown C Supply. Their agreement gave the survivor an option to buy the shares, and if he declined, the corporation had to redeem them. The company owned $3.5 million of life insurance on each brother. When Michael died, the company redeemed his shares for $3 million, and the estate reported them as worth $3 million.
The IRS valued the company at $6.86 million, the $3.86 million enterprise value plus the $3 million of proceeds, and assessed $889,914 in extra estate tax. The Court agreed: a redemption obligation does not reduce company value for estate tax, and the proceeds count as a corporate asset.
The Court also noted that a cross-purchase agreement would have avoided the problem, because the proceeds would have gone to Thomas personally. Connelly does not tell any owner to restructure. If your agreement is entity-purchase funded with company-owned insurance, ask your attorney and CPA to review it.
How to size a buy-sell policy: start with the share value
Sizing a buy-sell policy is sizing the purchase price. The policy should cover the price the agreement sets, whether by formula, fixed price, or appraisal, reviewed each year.
Take a two-owner business worth $1.2 million, owned 50-50. Each share is worth $600,000, so each owner needs a $600,000 policy on the other. If the business grows to $2 million, each share becomes $1 million, and the policies must grow with it.
Write down the business value, each share value, and the policy amount that matches it, then review them yearly with the agreement.
How to size key person cover: three methods, one answer
Key person cover is sized to the business’s loss, not to salary alone. Three methods are commonly cited, and they give different answers, so use all three and take the largest defensible number.
The methods are: 5 to 10 times annual compensation for an owner or executive, and 3 to 5 times for a sales or technical role; 1 to 3 years of gross profit attributable to the key person; and replacement cost plus lost revenue during the 12 to 18 months before a replacement is fully productive.
Take a small agency with $800,000 in revenue and $200,000 in profit. The founder brings in half the revenue and holds the main client relationships. Her compensation is $150,000 a year.
| Method | Calculation | Amount |
|---|---|---|
| Compensation multiple | $150,000 times 5 to 10 | $750,000 to $1,500,000 |
| Profit contribution | Half of $200,000 profit, times 2 years | $200,000 |
| Replacement cost plus lost revenue | Recruiting $50,000, signing bonus $50,000, lost revenue $200,000 | $300,000 |
| Working amount | Largest defensible method, rounded | $1,000,000 |
In this example, the compensation multiple gives the largest number, and $1,000,000 is a reasonable working amount. Run all three methods, see which captures the real exposure, and document the reasoning. A 10-year or 20-year term is the usual fit.
A worked example: one 2-owner shop, three policies
Take a two-owner landscaping company worth $1 million, owned 50-50. Owner A runs the crews and holds the contracts, and is the key person. Owner B runs the office.
| Policy | Who owns it | Who is insured | Amount | Who gets paid | What it funds |
|---|---|---|---|---|---|
| Buy-sell, cross-purchase | Owner B, on Owner A | Owner A | $500,000 | Owner B | Buys Owner A’s share |
| Buy-sell, cross-purchase | Owner A, on Owner B | Owner B | $500,000 | Owner A | Buys Owner B’s share |
| Key person | The business, on Owner A | Owner A | $750,000 | The business | Keeps the business running |
That is three policies for two owners. If Owner A dies, Owner B receives $500,000 to buy the share, and the business receives $750,000 to cover lost contracts and hire a replacement. Premiums are not quoted here, because they depend on age, health, amount, and term.
Checklist: from a handshake to a funded agreement
- Write down who owns what percentage, and what the business is worth today.
- Read the buy-sell agreement, or write one if there is none.
- Decide the structure with an attorney and a CPA, with Connelly in mind.
- Size buy-sell policies to the share values, and key person cover with all three methods.
- Calendar an annual review of the agreement, the business value, and the policy amounts on the same date.
- Keep a copy of the agreement, the policies, and the beneficiary confirmations in one file.
Common mistakes to avoid
Having no agreement, only a policy. A policy with no agreement pays money, but no one has agreed what it buys. The agreement comes first.
Insuring everyone equally instead of insuring the exposure. A policy on a replaceable manager wastes premium, while no policy on the rainmaker leaves the real risk uncovered.
Forgetting the annual review. A business that doubles leaves its buy-sell policies half funded.
Choosing entity-purchase without asking about Connelly. If the business owns the policies, the proceeds can inflate the taxable estate. Ask your attorney and CPA whether your structure still fits.
Mixing personal and business needs in one policy. Family income replacement belongs in a personal policy. Business needs belong in business policies.
Frequently asked questions
Do I need a buy-sell agreement if I am the sole owner?
No, there is no co-owner to buy out, but you still need a plan for what happens to the business if you die, and personal life insurance for your family.
Can the business pay the premiums on a buy-sell policy I own personally?
Ask your attorney and CPA. Who pays, who owns, and who is taxed can all differ.
Does key person cover pay my family?
No. It pays the business. Family income protection needs a separate personal policy.
What if my partner and I cannot agree on the business value?
That is what the agreement’s valuation formula is for. Agree on the formula while you are both alive, and let it set the price later.
Get a life quote
If you have a share value and a key person amount in mind from the examples above, the next step is to get a quote for the personal cover in that plan.
AcquireInsQuotes may earn a commission if you buy through a link on this page. AcquireInsQuotes is not an insurer and is not a licensed agent. This article is consumer education only, not personalized advice, and it does not promise approval, a rate, or an outcome from any carrier.
Sources
- LifeQuote, "Investing in Security: Life Insurance Strategies for Business Owners." lifequote.com
- Supreme Court of the United States, Connelly v. United States, 602 U.S. 257 (2024). Summary via Kraus Law. kraus.law
- Prime Law Group, "Buy-Sell Agreement and Life Insurance." primelawgroup.com
- LegalClarity, "Buy-Sell Agreement Facts: Funding, Types, and Tax Traps." legalclarity.org
- Local Life Agents, "Key Man Insurance." locallifeagents.com
- LegalClarity, "What Is a Keyman Insurance Policy and How Does It Work?" legalclarity.org
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- Life insurance guides
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