How to Fund an LLC Buy-Sell Agreement with Life Insurance

Members of a multi-member LLC who are smart will have signed a well-drafted operating agreement that contains a Buy Sell Agreement that says the surviving members or the LLC must buy a deceased member's interest. That promise is worthless unless somebody has the cash on the day the member dies. Life insurance is the only funding method that delivers a large amount of tax-free cash at the exact moment it is needed, and it is the reason most Buy Sell Agreements authorize the members or the company to purchase policies on the members' lives.

 

This article explains how to fund the death buyout with life insurance: who should own the policies, what changes when the buyer is the LLC instead of a living member, how the answer differs for a two-member LLC and a three-member LLC, what kind of policy to buy, and what kind of insurance agent you should hire.

 

Updated September 20, 2026

Contents

• A Buy Sell Agreement Without Money Is Just a Promise
• The Three Ways to Pay for a Deceased Member's Interest
• Who Should Own the Policies: The LLC or the Members?
• Connelly v. United States: The Case That Changed the Math
• Two-Member Arizona LLCs
• Three-Member Arizona LLCs
• What Kind of Life Insurance Should You Buy?
• How Much Insurance Do You Need?
• Six Tax Traps That Can Wreck the Plan
• What Kind of Insurance Agent Should You Use?
• Arizona Issues Members Forget
• A 12-Step Funding Checklist
• Frequently Asked Questions
• Cost and How to Hire Us

A Buy Sell Agreement Without Money Is Just a Promise

Under Arizona law a member is dissociated from the LLC when the member dies. See A.R.S. §29-3602(6)(a). Dissociation does not make the deceased member's economic rights disappear. Those rights pass to whoever inherits them. The heir becomes a transferee who is entitled to the deceased member's share of every distribution the LLC makes, forever, but who has no right to manage the company or vote. See A.R.S. §29-3502.

 

That is the nightmare a Buy Sell Agreement is designed to prevent. Without one, the surviving members end up in business with a grieving spouse, a son-in-law, four children who cannot agree, or a probate court. With one, the operating agreement obligates the LLC or the surviving members to buy the deceased member's interest at a stated price, and the family gets cash instead of a permanent minority stake in a company they cannot control.

 

Arizona's LLC Act lets the members write these rules themselves in the operating agreement. See A.R.S. §29-3105. But the Act cannot create money. If the agreement says the company must pay the estate $1,400,000 within 60 days of death and the company has $46,000 in the bank, the agreement is a lawsuit waiting to happen.

The Three Ways to Pay for a Deceased Member's Interest

There are only three sources of money for a death buyout, and two of them are bad.

1. Cash on hand

Almost no small Arizona LLC keeps six or seven figures of idle cash sitting in a bank account waiting for a member to die. Money that is set aside for a buyout is money that is not buying equipment, inventory, or payroll. And if the member dies in year two, the sinking fund has almost nothing in it.

2. A promissory note paid out of future profits

This is the most common default. The LLC or the surviving members sign a note to the estate payable over five to ten years with interest. It works, but it has real costs. The family becomes an unsecured creditor of a business now missing one of its producers. The survivors are paying yesterday's owner out of today's cash flow, often while revenue is falling because the deceased member was the rainmaker. Banks and bonding companies see the note as debt. And if the business fails, the family collects nothing.

 

A note is a sensible backup. It is a poor primary plan.

3. Life insurance

A life insurance policy converts a small, predictable annual premium into a large, tax-free lump sum delivered within weeks of the death. The death benefit is generally excluded from gross income under Internal Revenue Code §101(a). The family is paid in full immediately, the survivors keep 100% of the company, and the lender, the bonding company, and the key employees all see a business that survived the death of an owner intact.

 

The trade-off is that premiums are not deductible. Because the death benefit is tax free, IRC §264(a)(1) denies a deduction for premiums paid on a policy where the payer is directly or indirectly a beneficiary. Every dollar of premium is an after-tax dollar. That is the price of admission.

Who Should Own the Policies: The LLC or the Members?

This is the single most important design decision, and it is the one most often made by accident. There are three structures.

Structure 1: Entity purchase (also called a redemption)

The LLC buys a policy on the life of each member. The LLC owns the policy, pays the premiums, and is the beneficiary. When a member dies, the LLC collects the death benefit and uses it to redeem the deceased member's interest from the estate. The surviving members pay nothing personally, and their percentages increase automatically because the total number of outstanding interests goes down.

 

What is good about it. It is simple. A three-member LLC needs three policies, not six. There is one premium payer, so nobody has to police whether another member is keeping a policy in force. Members of different ages and health ratings share the total premium cost according to their ownership percentages rather than each paying for the other's risk. And the paperwork is centralized in the company's records.

 

What is bad about it. Four things, and the first one is serious:

• The death benefit is an asset of the LLC on the date of death, which can increase the estate tax value of the interest the company is about to buy. This is the holding of Connelly v. United States, discussed below.
• The proceeds are company money, so the LLC's creditors can reach them. A judgment creditor or a bank with a blanket lien does not care that the cash was earmarked for a buyout.
• Company-owned policies on members who are also employees are "employer-owned life insurance" governed by IRC §101(j). If the written notice and consent steps are not completed before the policy is issued, the death benefit becomes taxable income above the premiums paid. See the tax traps section below.
• In a corporation, an entity redemption gives the survivors no increase in the tax basis of the stock they already own. An Arizona LLC taxed as a partnership can largely fix this with an election under IRC §754, which is a genuine advantage LLCs have over S corporations here. It requires that your CPA make the election and track it.

Structure 2: Cross-purchase

Each member personally buys a policy on the life of each other member. Each member owns the policy on the other member's life, pays the premiums with personal after-tax dollars, and is the beneficiary. When a member dies, the survivors collect the death benefits personally and use the cash to buy the deceased member's interest directly from the estate.

 

What is good about it.

• The death benefit is never owned by the LLC, so it does not inflate the value of the company for estate tax purposes. This is the Connelly-proof structure, and the Supreme Court said so.
• The surviving members get a full cost basis in what they buy. A member who pays $900,000 for a one-third interest has $900,000 of additional basis, which reduces the taxable gain when the business is later sold. In an entity redemption without a §754 election, that benefit is lost.
• The insurance money sits outside the company, beyond the reach of the LLC's creditors.
• For an LLC taxed as a partnership, the transfer-for-value rule has a built-in exception for transfers to a partner of the insured, which makes it far easier to move policies around later without poisoning the tax-free death benefit.

What is bad about it.

• The number of policies explodes. The formula is n × (n − 1). Two members need 2 policies. Three members need 6. Four members need 12. Five members need 20.
• Premiums are unequal and personal. A 38-year-old insuring a 64-year-old partner pays far more than the 64-year-old pays to insure him. Members frequently feel this is unfair and need an equalizing side agreement or a company bonus.
• Nobody is watching. If a member quietly stops paying premiums on a policy insuring another member, the other members usually do not find out until the funeral. Cure this with an escrow or premium-verification provision in the operating agreement.
• Leftover policies. When a member dies, the policies he owned on the surviving members' lives are assets of his estate. Those policies have to be bought back or surrendered, which raises transfer-for-value questions.

Structure 3: Wait-and-see (hybrid)

The agreement does not lock in the buyer. On a death, the surviving members get the first option to buy; whatever they decline, the LLC must redeem. This preserves flexibility to make the decision with the tax law and the balance sheet that exist on the date of death rather than the ones that existed when the agreement was signed.

 

Wait-and-see is attractive, but it does not escape Connelly by itself. If the LLC is the entity that owns the policies and receives the death benefit, the proceeds are in the company on the date of death regardless of who ultimately signs the purchase agreement. To get the flexibility and keep the proceeds out of the company, the policies have to be owned outside the LLC, typically by the members or by an insurance LLC.

Connelly v. United States: The Case That Changed the Math

On June 6, 2024, a unanimous United States Supreme Court decided Connelly v. United States, and every entity-purchase Buy Sell Agreement in America became less attractive overnight.

 

Michael and Thomas Connelly owned Crown C Supply, a St. Louis building supply company. Michael owned 77.18% and Thomas owned 22.82%. Their agreement said that if a brother died, the survivor could buy his shares, and if the survivor declined, the company had to redeem them. Crown bought $3.5 million of life insurance on each brother to fund the redemption.

 

Michael died in 2013. Thomas declined to buy, so Crown redeemed Michael's shares for $3 million using the insurance money. The estate reported the shares at $3 million. The IRS said the company was worth $6.86 million because the $3.5 million of insurance proceeds was a corporate asset on the date of death, which made Michael's 77.18% worth $5.3 million. The extra estate tax was about $889,000.

 

The estate argued that the obligation to redeem the shares was a liability that offset the insurance asset. Justice Thomas, writing for a unanimous Court, rejected that argument:

A corporation's contractual obligation to redeem shares is not necessarily a liability that reduces a corporation's value... a fair-market-value redemption has no effect on any shareholder's economic interest.

The Court then pointed to the fix in plain language: the brothers could have used a cross-purchase agreement, in which each brother owns and is the beneficiary of a policy on the other, and the insurance money never touches the company.

Connelly carries a second lesson that has nothing to do with insurance. The brothers' agreement said the price would be set each year by a certificate of value the brothers signed, or by appraisals if they did not. They never signed a certificate and never got an appraisal. Because they did not follow their own agreement, the agreed price did not fix the value for estate tax purposes. A Buy Sell Agreement only controls estate tax value if it satisfies IRC §2703 and the members actually do what it says. Sign the certificate of value every year.

Two-Member Arizona LLCs

The two-member LLC is the easy case, and in most cases the answer is a cross-purchase.

 

Two members need only two policies. Member A owns and pays for a policy on Member B's life and is its beneficiary. Member B owns and pays for a policy on Member A's life and is its beneficiary. When A dies, B collects the death benefit personally, pays it to A's estate, and owns 100% of the LLC. B's tax basis in what she bought equals what she paid. The insurance money never entered the company, so Connelly is irrelevant, and the LLC's creditors never had a claim on it.

 

There is one more wrinkle worth knowing. When a two-member LLC taxed as a partnership becomes a one-member LLC, the partnership terminates for federal tax purposes and the surviving member is treated as having purchased the deceased member's share of the LLC's assets. That usually produces a basis step-up in the underlying assets, which is a good result. Tell your CPA the transaction is coming before it closes, not in March of the following year.

When a two-member cross-purchase does not work

• One member is uninsurable or rated. If one member cannot buy coverage at a sane price, look at a smaller death benefit plus a promissory note for the balance, a graded-benefit or guaranteed-issue policy, or an entity purchase so the premium burden is shared.
• Large age gap. A 34-year-old insuring a 67-year-old may pay five or ten times what the older member pays. Fix it with a cash bonus from the LLC to the younger member, an adjusted distribution or salary, or by having the LLC pay both premiums as a guaranteed payment reported as income to each member.
• One member has no personal cash. If a member cannot reliably fund premiums from personal funds, the policy will lapse. An entity purchase or a bonus arrangement is more honest than a cross-purchase that is going to fail quietly.
• Only one direction matters. If one member is 80 and the other is 40, a "one-way" buy-sell in which only the younger member buys insurance on the older is cheaper and reflects reality.

Three-Member Arizona LLCs

Three members is where the cross-purchase starts to hurt. A straight cross-purchase needs six policies: each of the three members owns a policy on each of the other two. Six applications, six underwriting files, six premium schedules, six sets of beneficiary designations, and six chances for somebody to make a mistake. There are four ways to handle it.

Option A: Just buy the six policies

If the members are similar in age and health and the death benefits are modest, six term policies are not as bad as they sound. A good agent will run all six through the same carriers and align the anniversary dates so you get one annual review instead of six. This option keeps every advantage of the cross-purchase with no exotic structure to defend if the IRS ever looks.

Option B: A separate insurance LLC

The three members form a second Arizona LLC whose only business is owning the policies. The insurance LLC buys one policy on each member (three policies, not six), and the members own the insurance LLC in proportions that mirror the operating company. On a death, the insurance LLC collects the death benefit and distributes it to the surviving members, who then buy the deceased member's interest in the operating company.

 

This structure cuts the policy count from six to three and adds a useful feature: because all of the members are "partners" of each other in the insurance LLC, the transfer-for-value exception in IRC §101(a)(2) for a transfer to a partner of the insured applies, so policies can be moved among them without turning the death benefit into taxable income.

 

The insurance LLC must be drafted carefully, and this is not a do-it-yourself project. Two provisions are essential. First, the operating agreement of the insurance LLC must specially allocate the death proceeds to the surviving members, not pro rata to everyone including the decedent's successor. Second, the deceased member's interest in the insurance LLC itself must be redeemed or liquidated for a nominal amount at death, or you have simply moved the Connelly problem from one entity to another. The insurance LLC also needs to be respected as a real entity, with its own records, its own bank account, and its own tax return.

Option C: A trusteed cross-purchase

The members sign an escrow or trust agreement, and a trustee holds the policies as agent for the individual members. Each member's rights in the policies are defined by the trust agreement, and the trustee handles premiums, claims, and the purchase. It reduces administration without forming a second company.

 

The risk is characterization. If the LLC pays the premiums, if the LLC is named anywhere as an owner or beneficiary, or if the trustee is really acting for the company, the IRS can treat the arrangement as company-owned insurance and you are back inside Connelly. The premiums must come from the members, and the paperwork must be consistent from the first application forward.

Option D: Entity purchase, with your eyes open

Three policies, one payer, one set of records, and the simplest administration of any option. Given the 2026 exemption of $15 million per person, a three-member LLC whose owners each have estates of $3 million or $5 million may reasonably decide that Connelly is an academic problem and that the administrative simplicity is worth more. That can be the right call. Just make it deliberately, in writing, after the members have been told what they are giving up, and revisit it if the business grows or the exemption shrinks.

Side-by-side

	2 members	3 members	4 members
Cross-purchase policies	2	6	12
Entity purchase policies	2	3	4
Insurance LLC policies	2	3	4
Survivors get basis step-up	Cross-purchase: yes	Cross-purchase: yes	Cross-purchase: yes
Connelly exposure	Entity purchase only	Entity purchase only	Entity purchase only

What Kind of Life Insurance Should You Buy?

The structure question is who owns the policy. This question is what kind of policy it should be. There are only two real families of product, and the choice turns on how long the need lasts.

Level term insurance

Level term is a pure death benefit for a fixed number of years at a fixed premium: 10, 15, 20, 25, or 30 years. It is dramatically cheaper than permanent insurance for the same death benefit, which means that for any given budget, term buys the most protection.

 

Term is the right choice for most buy-sell funding, and especially when:

• The members expect to sell the business, retire, or wind down within a definable period.
• The members are in their 30s, 40s, or 50s and the premium difference between term and permanent is large.
• Cash flow is tight and the alternative to term is no insurance at all, which is the worst outcome of all.

Two requirements when you buy term. First, buy convertible term, with a conversion privilege that runs as far into the term as you can get and that lets you convert to a permanent policy with no new medical underwriting. Health changes. The conversion privilege is what saves a member who becomes uninsurable at 58 and still owns a third of the company. Second, match the term length to the buy-sell need, not to the cheapest quote. A 10-year policy on a 54-year-old member who intends to work until 70 guarantees a crisis at 64, when replacement coverage is expensive or unavailable.

Permanent insurance

Permanent insurance (whole life, guaranteed universal life, indexed universal life) stays in force for life as long as it is funded, and it accumulates cash value. It costs multiples of term for the same death benefit. It earns its price in specific situations:

• The need is permanent. A member who intends to own the interest until death, and whose family is counting on the buyout, needs coverage that is still there at 84. Term will be gone.
• The same policy will fund a lifetime buyout. Many Buy Sell Agreements also require a purchase on retirement or disability. Cash value in a permanent policy can be borrowed or withdrawn to fund a retirement buyout of the same member the policy insures, so one premium serves two triggers.
• The business is the estate plan. If the LLC is the bulk of a member's net worth and the estate will need liquidity, permanent coverage does double duty.
• Insurability is already a problem. If a member is rated today, locking in permanent coverage now may be cheaper over a lifetime than repeated term renewals.

Within the permanent category, guaranteed universal life with a no-lapse guarantee to age 100 or later is the low-cost way to buy a permanent death benefit when you do not care about cash value. Whole life from a mutual carrier costs more but has guaranteed cash value and dividends. Indexed universal life shifts investment risk and illustration risk to you; be skeptical of any illustration that projects a high crediting rate forever, and ask to see the same policy illustrated at the guaranteed rate.

A layered approach

Many multi-member LLCs land on a combination: a permanent base equal to the minimum buyout amount the members are confident will be needed someday, plus a layer of level term equal to the additional value the business has today and may have for the next 15 or 20 years. As the business grows, the term layer grows. As members approach retirement, the term layer is dropped.

What not to rely on

• Group term life through the company's benefit plan. The limits are low, coverage ends when employment ends, and using it for a buyout creates the §101(j) problem described below.
• Accidental death policies. They pay nothing for the heart attack, the stroke, or the cancer, which is how most members actually die.
• Annually renewable term held for decades. The premium is cheap at 45 and brutal at 68, which is exactly when the policy is most likely to be needed.
• Life insurance alone. A member is far more likely to be disabled before 65 than to die before 65. If your Buy Sell Agreement has a disability trigger, fund it with a separate disability buy-out policy. Life insurance pays nothing for a member who is permanently disabled but alive.

How Much Insurance Do You Need?

The death benefit should equal the buyout price the agreement will produce, not the price the business was worth when the members signed the operating agreement. Four practical rules:

• Insure the value, member by member. If the company is worth $3 million and a member owns 40%, the policy on that member is $1.2 million, not $3 million and not $1 million split evenly.
• Add the debt the death will accelerate. Personal guarantees, lines of credit that a lender will call, and bonding requirements all consume cash on the same day the buyout does.
• Add a replacement cushion. The business will lose revenue and pay to replace the deceased member. Many agreements add six to twelve months of that member's compensation.
• Re-value annually and sign the certificate of value. Set a fixed date each year, agree on a price, sign it, and compare it to the total death benefit in force. That single habit cures the most common failure in buy-sell funding, which is a $500,000 policy backing a $2,000,000 obligation, and it is exactly the step the Connelly brothers skipped.

Six Tax Traps That Can Wreck the Plan

1. The transfer-for-value rule

Under IRC §101(a)(2), if a life insurance policy is transferred for valuable consideration, the death benefit is taxable income to the extent it exceeds what the buyer paid plus later premiums. The exceptions are narrow: a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is a shareholder or officer, or a transfer with a carryover basis.

 

Notice what is missing: there is no exception for a transfer to a co-shareholder. Shareholders of a corporation who swap policies in a cross-purchase can blow up the exclusion. Members of an LLC taxed as a partnership are partners of each other, so the partner exception protects them. This is one of the quiet advantages of doing a cross-purchase inside an LLC taxed as a partnership rather than inside an S corporation, and it is why the insurance LLC works.

 

The trap shows up most often when the structure changes: switching from an entity purchase to a cross-purchase by selling the company's policies to the members, or buying the deceased member's policies back from his estate. Never move a policy without asking your tax adviser about §101(a)(2) first.

2. Employer-owned life insurance notice and consent

If the LLC owns a policy on a member who is also an employee, IRC §101(j) makes the death benefit taxable income above the premiums paid unless two things happened before the policy was issued: the insured received written notice that the company intended to insure his life, stating the maximum face amount, and that the company would be a beneficiary; and the insured gave written consent. The company must also file Form 8925 with its tax return each year.

 

This step is missed constantly, and it cannot be fixed after the fact. A policy issued in 2019 without the notice and consent is still defective in 2036 when the member dies, and the IRS will tax the proceeds. If your LLC owns policies on members, pull the file today and confirm the signed notice and consent is in it.

3. Premiums are not deductible

IRC §264(a)(1) denies a deduction for premiums on a policy covering an officer, employee, or any person financially interested in the business when the taxpayer is directly or indirectly a beneficiary. Do not let anyone tell you the company can write off buy-sell premiums. A premium paid by the LLC is a nondeductible expense that reduces the members' bases.

4. Allocating the tax-free proceeds in a partnership

When an LLC taxed as a partnership receives a death benefit, the money is tax-exempt income that flows through and increases the members' outside bases. Under the default rules it is allocated among all the members according to their percentages, which includes the deceased member's successor. That gives the estate a basis increase it did not pay for and shortchanges the survivors. A properly drafted operating agreement specially allocates the death benefit to the surviving members. Most form operating agreements do not.

5. Basis and the §754 election

A deceased member's interest generally receives a stepped-up basis at death under IRC §1014, so the estate usually recognizes little or no gain on the sale. The question is what the buyers get. In a cross-purchase, the survivors get cost basis automatically. In a redemption, they get nothing unless the LLC makes an election under IRC §754, which permits the inside basis adjustment described in IRC §734(b). The election is a real benefit and a real administrative commitment, because once made it applies to future years as well.

6. A price the IRS will respect

A Buy Sell Agreement fixes the estate tax value of the interest only if it meets the requirements of IRC §2703: a bona fide business arrangement, not a device to transfer the interest to family members for less than full value, and terms comparable to what unrelated parties would agree to. Family-owned LLCs get extra scrutiny. A formula that has not been updated in a decade, or a price the members never actually documented, invites the IRS to substitute its own number.

What Kind of Insurance Agent Should You Use?

The policy is only as good as the person who designs and services it, and buy-sell funding is a specialty. Use these criteria.

Independent, not captive

A captive agent represents one carrier and can only sell you that carrier's product at that carrier's underwriting. An independent broker can shop the same application across a dozen companies. Underwriting classes for the same person vary enormously by carrier, especially with a history of high blood pressure, diabetes, sleep apnea, cancer, a DUI, or aviation. The price difference between the best and worst offer on a rated case is routinely 40% or more.

Experienced in business succession, not just personal coverage

Ask directly: "How many buy-sell cases have you funded, and how many involved an LLC taxed as a partnership?" An agent who has never heard of §101(j) or Connelly is going to sell you a personal life insurance policy and leave the structure to chance.

Credentialed

Look for CLU (Chartered Life Underwriter), ChFC, CFP, or CEPA. These are not guarantees of competence, but they signal training in exactly the estate and business planning issues this article covers.

Arizona licensed, and verifiable

Confirm the agent holds a current Arizona life insurance producer license and check the disciplinary history with the Arizona Department of Insurance and Financial Institutions. It takes two minutes.

Willing to shop a difficult health history informally first

A good broker submits an anonymous informal inquiry to several carriers before filing a formal application on a member with health problems. A declined formal application follows the member for years and makes the next application harder.

Willing to read the Buy Sell Agreement before recommending anything

This is the single best filter. The agreement dictates who must own each policy, who must be named beneficiary, and how much coverage is required. An agent who quotes a policy without reading the agreement will get the ownership and beneficiary designations wrong, and that error is what turns a funded plan into an unfunded one.

Transparent about compensation

First-year commissions on permanent insurance are a large multiple of the commission on level term for the same death benefit. That does not make permanent insurance wrong, but it does mean you should ask how the agent is paid and why the recommendation is not term. On a large permanent policy, a second opinion from a fee-based insurance consultant who takes no commission is money well spent.

Carrier strength matters

You are buying a promise that may not be collected for 40 years. Ask for the carrier's AM Best rating (A or better) and its Comdex score. On guaranteed universal life especially, the guarantee is only as good as the company behind it.

Annual service, in writing

Ask what the agent does every year. The right answer is a written review that compares the death benefit in force against the current certificate of value, confirms premiums are current, and confirms owner and beneficiary designations still match the agreement.

Arizona Issues Members Forget

Community property and the member's spouse

Arizona is a community property state. A membership interest acquired during a marriage with community funds is presumptively community property under A.R.S. §25-211, and management of community property is governed by A.R.S. §25-214. A Buy Sell Agreement signed by the member alone can be attacked later by a surviving spouse who says she never agreed to sell the family's largest asset at the price in a document she never saw.

 

The cure is simple and takes one page: have every member's spouse sign a consent to the operating agreement and Buy Sell Agreement agreeing to be bound by it, including on the member's death and on divorce. Get it signed when the agreement is signed, not when a member remarries at 61 and nobody thinks to ask.

The LLC interest and your revocable living trust

Many Arizona members hold their membership interest in a revocable living trust so that the interest passes at death without a Superior Court probate. This works well with a Buy Sell Agreement, but the agreement has to be drafted to recognize it: the trustee, not the deceased member, is the party who sells, and the agreement's transfer restrictions must permit the transfer into the trust in the first place. If your operating agreement flatly prohibits transfers, funding your trust with the interest may technically violate it.

 

A trust that owns the interest also keeps the member's name and address off the Arizona Corporation Commission's public records. That is one reason our Gold LLC formation package includes a revocable living trust that owns the LLC.

Put it in the operating agreement, and follow it

Arizona gives the members wide latitude to set their own rules in the operating agreement. A funded Buy Sell Agreement should state, at a minimum: the trigger events, who buys and in what order, the price or the formula, the annual certificate of value requirement, who owns each policy, who is the beneficiary, who pays the premiums, what happens if a premium is not paid, what happens if the death benefit is more than the price, what happens if it is less, and what happens to the policies when a member leaves alive.

A 12-Step Funding Checklist

1. Agree on a valuation method and put it in the operating agreement.
2. Sign a certificate of value now, and again every year on a fixed date.
3. Decide the structure: entity purchase, cross-purchase, insurance LLC, or wait-and-see. Write down why.
4. Confirm how the LLC is taxed, because partnership, S corporation, and C corporation taxation change the analysis.
5. Calculate the required death benefit for each member individually.
6. Hire an independent Arizona broker and give the broker the Buy Sell Agreement before any application is submitted.
7. If the LLC will own any policy on a member-employee, complete the §101(j) written notice and consent before the policy is issued, and calendar Form 8925 each year.
8. Verify every policy's owner and beneficiary designation against the agreement after the policies are issued. Do not assume the application was completed correctly.
9. Have every member's spouse sign a spousal consent.
10. Add a disability buy-out policy if the agreement has a disability trigger.
11. Store the policies, the notice and consent forms, the certificates of value, and the signed agreement in one place the survivors can find.
12. Review the whole package every year, and immediately whenever a member is added, leaves, marries, divorces, or the business changes value significantly.

Frequently Asked Questions

Is the life insurance death benefit taxable to the LLC or to the surviving members?

Generally no. IRC §101(a) excludes death benefits from gross income. The exceptions are the transfer-for-value rule and, for company-owned policies on member-employees, the employer-owned life insurance rules of §101(j). Both are discussed above, and both are avoidable if you plan before the policy is issued rather than after.

Can the LLC deduct the premiums?

No. IRC §264(a)(1) denies the deduction when the payer is directly or indirectly a beneficiary. Premiums are paid with after-tax dollars in every structure.

What happens if the death benefit is larger than the buyout price?

The agreement should say. In an entity purchase, the excess stays in the company and benefits the surviving members. In a cross-purchase, the excess stays with the surviving member who owned the policy. Either result can be fine, but it should be a choice, not a surprise. Some agreements direct a portion of any excess to the family as a death benefit, or use it to retire company debt.

What happens if the death benefit is too small?

The agreement should require the buyer to pay the shortfall, usually with a promissory note on stated terms: interest rate, number of years, security, and default remedies. Drafting the note terms in advance is what prevents a negotiation with a grieving family.

Can the LLC just pay the premiums on policies the members own personally?

Yes, but understand the tax treatment. For an LLC taxed as a partnership, premiums the company pays on a policy a member owns are typically treated as a guaranteed payment or distribution to that member, which is income to the member. Done deliberately and documented, this is a clean way to equalize premium costs in a cross-purchase between members of very different ages. Done casually, it creates a mess at tax time and can make the insurance look company-owned.

We already have an entity purchase plan. Should we tear it up because of Connelly?

Not automatically. Start by asking whether any member's estate is realistically going to approach the federal exemption, which is $15 million per person in 2026. If the answer is no for everyone, the Connelly exposure may be theoretical and the simplicity of the entity purchase is worth keeping. If the answer is yes for anyone, or the business is growing fast, review it with your attorney and CPA. Do not unwind a structure by moving policies around without a transfer-for-value analysis first.

Does Connelly apply to an LLC, or just to corporations?

Connelly was a corporate redemption case, but the valuation principle is not limited to corporations. An Arizona LLC that owns policies on its members and redeems a deceased member's interest faces the same argument: the insurance proceeds were a company asset on the date of death, and the obligation to redeem at fair value does not offset them.

What if one member cannot get insurance?

You still write the Buy Sell Agreement, and you fund what you can. Options include a smaller death benefit plus an installment note for the balance, guaranteed-issue or graded-benefit coverage, a sinking fund, a reduced buyout price for that member disclosed and agreed in advance, or coverage on the insurable members only so that at least those deaths are funded. The worst answer is to do nothing because the plan cannot be perfect.

Do we need a new LLC just to own the policies?

Only if the policy count or the Connelly exposure justifies the extra entity. For two members, no. For three or four members who want cross-purchase treatment without six or twelve policies, an insurance LLC can be worth the cost of a second entity, a separate tax return, and careful drafting. For a group that is comfortable with an entity purchase, no.

How often should the death benefit be adjusted?

Every year, at the same time you sign the certificate of value. Business values move, and a policy purchased when the company was worth $2 million is badly undersized when it is worth $7 million. Term insurance can usually be layered by adding a new policy rather than replacing the old one.

Should the Buy Sell Agreement be inside the operating agreement or a separate document?

Either works. Inside the operating agreement, everything lives in one place and every member has already signed it. In a separate agreement, the buy-sell terms can be amended without reopening the operating agreement, and the document can be shown to a lender, an insurance carrier, or an appraiser without disclosing the rest of the members' arrangements. What matters more than the location is that the terms are complete and that the members actually follow them.

What happens to the policies when a member leaves while alive?

This is the provision everyone forgets. The agreement should say whether the departing member may buy the policy on his own life from the company or from the other members, at what price, and by when, and it should say what happens to the policies the departing member owns on the remaining members' lives. Handle the transfers with a transfer-for-value analysis, because this is exactly the moment the rule bites.

Cost and How to Hire Us

How much does KEYTLaw charge to prepare a buy-sell agreement?

We charge a flat fee:

• $1,294 for an LLC formed within the last 90 days, or when we prepare the LLC's Operating Agreement at the same time.
• $1,994 for all other Arizona LLCs.

Each fee includes up to one hour of attorney time for consultation, modifications and custom provisions. Additional time is billed at $295 per hour.

How does the process work?

1. Complete our online Buy Sell Agreement Questionnaire.
2. Pay the fee online with the $1,294 order form or the $1,994 order form, by credit card over the phone, or by check.
3. Within 3 to 5 business days you receive the draft agreement and a letter of explanation.
4. The members review the draft and mark any changes.
5. Attorney Richard C. Keyt revises the agreement and sends the final version.
6. The members sign, and digital signatures can be arranged.

This article is general information about Arizona and federal law and is not legal, tax, or insurance advice. Life insurance and the taxation of business buyouts are fact-specific. Consult an Arizona attorney, your CPA, and a licensed insurance professional before acting. © 2026 KEYTLaw, LLC. All rights reserved.