S-Corp Buy-Sell Agreement: The Life Insurance Tax Trap
If your S-corp has more than one shareholder, you probably have a buy-sell agreement that promises the company will buy out a deceased or disabled owner’s shares. Most of those agreements are funded with life insurance the corporation owns on each shareholder, so the cash is there the day it’s needed. That structure works well — but only if the policy met IRC Section 101(j)’s notice-and-consent requirements before it was issued. Skip that paperwork and the death benefit meant to fund the buyout comes back partially taxable, which is the worst possible moment to discover a compliance gap.
How an S-Corp Buy-Sell Agreement Is Supposed to Work
Most S-corp buy-sell agreements use one of two structures. In a cross-purchase agreement, each shareholder personally owns a policy on every other shareholder and uses the payout to buy the deceased owner’s shares directly. In an entity-redemption agreement, the corporation itself owns the policies, collects the death benefit, and redeems the shares from the estate. Entity-redemption is far more common once there are three or more shareholders, because it avoids a multiplying number of cross-owned policies. It’s also the structure where the tax trap below actually bites, since the corporation — not an individual shareholder — is the policyholder and beneficiary. There’s a second reason the choice matters now: in Connelly v. United States (2024), the Supreme Court held unanimously that entity-owned death benefits increase the company’s fair market value for estate tax purposes, with no offset for the redemption obligation — a result that has pushed some multi-shareholder companies back toward cross-purchase when a shareholder’s estate might be large enough to owe estate tax.
How the actual redemption is taxed to the departing shareholder’s estate is a separate question, governed by Section 302’s sale-versus-dividend tests — we cover that mechanics in S-Corp Shareholder Redemption: The Sale vs. Dividend Trap. What this post covers is a different, earlier problem: whether the insurance proceeds that fund that redemption show up tax-free in the first place.
The Section 101(j) Notice-and-Consent Trap
Life insurance death benefits are generally tax-free under Section 101(a). But when an employer — and an S-corp shareholder who is also an officer or employee counts — owns a policy on its own employee and is the beneficiary, that’s an “employer-owned life insurance contract” under Section 101(j), and the general exclusion is capped. Under Section 101(j)(1), the corporation can exclude only the premiums and other amounts it actually paid for the policy, not the full death benefit, unless one of two exceptions applies.
Both exceptions require the same threshold condition: before the policy was issued, the insured employee had to be notified in writing that the company intended to insure them and for how much, had to give written consent to being insured (including consent that coverage could continue after they left employment), and had to be told in writing that the company would be a beneficiary of the proceeds. That’s Section 101(j)(4), and it has to happen before issuance. The only grace the IRS has offered is in Notice 2009-48: it won’t challenge a good-faith, inadvertent slip corrected by the due date of the return for the year the policy was issued — and nothing can be cured once the insured has died.
The Two Exceptions That Can Still Save the Exclusion
If notice and consent were obtained, Section 101(j)(2) opens up two paths back to full exclusion. The first is based on the insured’s status: the exclusion applies if the shareholder was an employee at any point in the 12 months before death, or was, when the policy was issued, a director, a highly compensated employee under Section 414(q), or a highly compensated individual under the modified Section 105(h)(5) test. Most active S-corp owner-employees clear this bar without difficulty — the exception exists precisely for people in their position.
The second path, under Section 101(j)(2)(B), applies regardless of the insured’s compensation level: the exclusion holds if the proceeds are paid to the insured’s family, designated beneficiary, or estate, or are used to buy an equity interest in the company from those people. A buyout funded through the estate fits this exception on its face. The catch is that this path is still conditioned on the same notice-and-consent requirement in Section 101(j)(4) — it doesn’t substitute for it. A policy issued without the paperwork doesn’t get a second chance under either exception.
The Annual Reporting Requirement Nobody Remembers
Separate from the exclusion question, any S-corp that owns one or more employer-owned life insurance contracts issued after August 17, 2006 has to file Form 8925 with its Form 1120-S every year the policies are in force, reporting how many employees are covered, the total coverage in force, and whether valid consent was obtained for each one. It’s a short form, but it’s one of those filings that quietly stops happening once the shareholder who set up the buy-sell agreement retires or the bookkeeper changes — and a missing Form 8925 is exactly what an IRS agent pulls first if a death benefit claim ever gets questioned.
Why the Payout Doesn’t Rebuild Your AAA
Even when the exclusion is clean, the proceeds don’t move through your S-corp’s books the way owners expect. Under Rev. Rul. 2008-42, premiums the corporation pays on a policy where it’s the beneficiary don’t reduce the Accumulated Adjustments Account, and death benefits that qualify under a Section 101(j)(2) exception don’t increase it either — both sides land in the corporation’s Other Adjustments Account instead. That matters the moment the company tries to distribute anything beyond the redemption itself. If the corporation has accumulated earnings and profits from a prior C-corp life, a cash infusion that never touched AAA can leave later distributions exposed to dividend treatment that a same-size increase in AAA would have avoided. We walk through how AAA tracks shareholder-level basis more broadly in S-Corp Shareholder Basis: How AAA and Stock Basis Work.
What This Means Before the Next Policy Renewal
None of this is a reason to avoid funding a buy-sell agreement with life insurance — it’s still the cleanest way to put cash in the corporation’s hands exactly when it’s needed, without forcing a fire sale or a note payable to a grieving family. The real complexity shows up in the specifics: whether your existing policies were issued with the Section 101(j) notice-and-consent paperwork in the file, whether Form 8925 has actually been filed every year, whether your agreement should be entity-redemption or cross-purchase given how many shareholders you have, and whether old C-corp earnings and profits are sitting on your balance sheet waiting to turn a clean death benefit into a taxable distribution. If you’re updating a buy-sell agreement — or have never checked whether an existing one would hold up — talk to us before the next policy renewal, not after a claim is filed.