A cross-purchase buy-sell funded with life insurance can be inexpensive to set up and fund. But when there are three or more owners, the first death can move policy ownership in a way that exposes the survivors to transfer-for-value tax on the next death benefit.
Key takeaways
- When jointly owned buy-sell policies change hands after an owner’s death, the transfer can violate the transfer-for-value rule.
- A violation can make part of the death benefit taxable income to the new owner.
- A planned ownership reset after the first death, reviewed by a tax advisor, can often solve the problem at lower cost than restructuring up front.
The shift in policy ownership caused by the first death is probably a transfer for value, and a large part of the next death benefit could become taxable.
How the problem arises
Consider three young, healthy owners, Sharon, Caroline and Andrea, who run an LLC taxed as an S corporation. They agree to buy out any owner’s estate for $1,000,000, and each is insured for that amount. The two non-insured owners jointly own each policy. Sharon and Caroline, for example, own the policy on Andrea.
If Andrea dies, her policy funds the purchase of her interest. But her share of the two remaining policies passes to the survivors, so Sharon becomes sole owner of the policy on Caroline and vice versa. That change in ownership for value is likely a transfer for value, which can cause the death benefit, less the new owner’s basis, to become taxable income.
The exceptions and why they may not help here
Transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner or to a corporation in which the insured is a shareholder or officer are exceptions. The most common fix is a partner-to-partner transfer. But these owners are taxed as an S corporation, and co-shareholders are not an exception. Converting to partnership taxation, or forming a separate partnership just to hold the policies, may cost far more than the annual premium, all to prevent a tax that only arises if a second death occurs while they are still in business.
A practical approach: plan the reset
A reasonable approach is to document, with the client’s tax advisor, a plan to reset ownership if a first death occurs:
- Transfer each remaining policy back to its insured, an exception that also cleanses the policy of prior transfer-for-value taint.
- Form a partnership between the surviving owners, incurring the cost only when it is actually needed.
- Have the owners exchange policies so each owns the policy on the other, now protected by the partner exception.
Put the recommendation in writing for the client and their tax advisor, and keep a copy in your file to show the issue was raised. Our article on cross-purchase buy-sell agreements covers the broader design.
What about entity redemption?
Having the business own the policies avoids multiple cross-owned contracts. After Connelly v. United States (2024), however, company-owned life insurance used to redeem a deceased owner’s shares can increase the company’s value for estate tax purposes. Each structure has trade-offs, and SRS can help you and the client’s advisors compare them.
Frequently asked questions
What is the transfer-for-value rule?
If a life insurance policy is transferred for valuable consideration, the death benefit can become taxable income to the new owner, less what they paid and later premiums, unless an exception applies.
Are S corporation shareholders covered by the partner exception?
No. Co-shareholders are not an exception. A transfer to the corporation itself, or to the insured, can qualify.
Does a trusteed cross-purchase avoid the issue?
It can simplify ownership with many owners, but the trust arrangement must be carefully drafted. The client’s attorney should review how transfers are handled after a death.
Reviewed by Tim Fuller on 2026-09-26
Tim Fuller
President, SRS Inc.
Tim leads SRS Inc., a full-service IMO (Independent Marketing Organization) and BGA (Brokerage General Agency), connecting independent financial professionals with life, annuity, disability income, and long-term care solutions from 60+ carrier partners.
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