Every business partnership ends eventually. The only question is whether the ending is orderly or chaotic.
A buy-sell agreement is a legally binding contract between business owners that governs what happens to an owner’s interest when they leave the company, whether by choice, by circumstance, or by death. Think of it as a prenuptial agreement for your business: you negotiate the terms while everyone is still getting along, so the rules are clear when things change.
If you own a Minnesota business with one or more partners, and you do not have a buy-sell agreement, you are relying on default statutory rules and the goodwill of people who may no longer be in a position to exercise it. This guide explains how buy-sell agreements work, why they matter, and what Minnesota business owners specifically need to consider.
What a Buy-Sell Agreement Does
At its core, a buy-sell agreement answers three questions:
- When can (or must) an owner’s interest be bought or sold? These are the trigger events.
- How will the interest be valued? This is the valuation mechanism.
- How will the purchase be funded? This is the payment structure.
Without a buy-sell agreement, these questions get answered by default statutory rules, probate courts, or litigation. None of those options are fast, cheap, or predictable.
Trigger Events
A well-drafted buy-sell agreement covers every significant event that could change the ownership structure:
Involuntary triggers:
– Death of an owner
– Permanent disability or incapacity
– Bankruptcy or creditor claims against an owner’s interest
– Divorce (to prevent a former spouse from becoming a co-owner)
– Involuntary transfer by operation of law
Voluntary triggers:
– Retirement or planned departure
– Voluntary withdrawal from the business
– Termination of employment (when the owner is also an employee)
– Desire to sell to a third party (often with a right of first refusal)
Company-level triggers:
– Removal from management (see [Removing a Business Officer Who Won’t Step Down])
– Breach of a non-compete or operating agreement
– Irreconcilable deadlock between owners
Each trigger event can have different terms. A death buyout funded by insurance operates differently than a voluntary departure funded by installment payments. The agreement should address each scenario specifically rather than applying a one-size-fits-all approach.
The Three Structures: Cross-Purchase, Entity Redemption, and Hybrid
The structural choice has significant legal and tax consequences. Minnesota business owners need to understand the tradeoffs.
Cross-Purchase Agreement
In a cross-purchase arrangement, the remaining owners personally buy the departing owner’s interest.
How it works: Owner A dies. Owners B and C each purchase a portion of Owner A’s interest directly from A’s estate.
Advantages:
– Stepped-up basis. The surviving owners receive a tax basis in the purchased interest equal to the amount they paid for it. This reduces capital gains tax if they later sell the company.
– Simplicity for two-owner businesses. With only two owners, there is only one buyer and one seller.
– No corporate-level tax issues. The purchase is between individuals, avoiding complications with corporate earnings and profits.
Disadvantages:
– Complexity with multiple owners. In a five-owner business, each owner would need life insurance policies on every other owner. The number of policies grows exponentially.
– Unequal financial burden. If owners have unequal interests, the buyout obligation falls disproportionately on some owners.
– Personal financing required. Each owner must fund the purchase from their own resources or personal borrowing.
Entity Redemption Agreement
In an entity redemption (also called a stock redemption for corporations or interest redemption for LLCs), the company itself buys the departing owner’s interest.
How it works: Owner A dies. The company purchases Owner A’s interest from A’s estate. The remaining owners’ percentage interests increase proportionally without them spending personal funds.
Advantages:
– Administrative simplicity. The company holds one insurance policy per owner and manages the buyout process.
– Equal treatment. All owners benefit proportionally from the redemption without individual financial obligations.
– Works well for companies with cash flow. The business may have access to financing options unavailable to individual owners.
Disadvantages:
– No basis step-up for survivors. The remaining owners do not receive an increased tax basis in their ownership interests. This can result in significantly higher capital gains tax on a future sale.
– Connelly v. United States (2024). In this unanimous Supreme Court decision, the Court held that when a corporation owns life insurance to fund a buy-sell redemption, the insurance proceeds are included in the value of the company for estate tax purposes. This means the deceased owner’s estate may owe estate taxes on the full company value including the insurance, even though those proceeds are being used to buy out the deceased owner’s shares. This decision fundamentally changes the estate tax calculus for entity redemption agreements funded by life insurance.
– Corporate tax complications. For C corporations, a redemption that does not qualify under the sale-or-exchange rules may be recharacterized as a dividend, resulting in double taxation.
Hybrid (Wait-and-See) Agreement
A hybrid structure gives the company the first option to redeem the departing owner’s interest, with the remaining owners having a secondary cross-purchase right if the company does not exercise its option (or vice versa).
Advantages:
– Flexibility. The owners can decide at the time of the trigger event which structure produces the best tax result.
– Addresses Connelly concerns. By preserving the cross-purchase option, the agreement can potentially avoid the estate tax inflation caused by entity-owned insurance.
Disadvantages:
– More complex drafting. The agreement must clearly define the option periods, decision-making process, and fallback provisions.
– Uncertainty. The selling party does not know in advance whether the company or the individuals will be the buyer.
Minnesota-Specific Structural Considerations
Minnesota’s tax treatment affects the structural choice:
- No entity-level income tax for LLCs taxed as partnerships or S corporations. This reduces the risk of double taxation on redemptions, making entity redemption more attractive for pass-through entities than for C corporations.
- Minnesota follows federal treatment on S corporation basis rules. An S corporation redemption does not create the same dividend recharacterization risk as a C corporation redemption, but the basis step-up issue remains.
- Minnesota estate tax. Minnesota has its own estate tax with an exemption significantly lower than the federal exemption. For 2026, the Minnesota estate tax exemption is $3 million, compared to the federal exemption of approximately $13.99 million. This means the Connelly decision has outsized impact for Minnesota business owners whose estates fall between the state and federal exemption thresholds.
Valuation: The Provision That Causes the Most Disputes
A buy-sell agreement is only as good as its valuation mechanism. If the price is wrong, the agreement either overcompensates the departing owner (at the expense of the remaining owners) or undercompensates them (inviting litigation from their estate or successors).
Common Valuation Methods
Fixed price. The owners agree on a specific dollar value, typically updated annually.
- Advantage: Certainty and simplicity.
- Risk: Owners forget to update the price. A value set three years ago may bear no relationship to current fair market value. Outdated fixed prices are the single most common buy-sell agreement failure.
Formula-based. The agreement specifies a formula, such as a multiple of revenue, EBITDA, or book value.
- Advantage: Automatically adjusts as the business grows.
- Risk: Formulas can produce results that diverge significantly from true fair market value, particularly for service businesses, asset-heavy businesses, or businesses with lumpy revenue.
Independent appraisal. A qualified appraiser determines fair market value at the time of the trigger event.
- Advantage: Most accurate reflection of current value.
- Risk: Cost, time delay, and potential for dueling appraisals. The agreement should specify whether one appraiser or a panel is used, what standard of value applies, and how disputes are resolved.
Agreed value with appraisal fallback. The owners set a value annually, but if the value has not been updated within a specified period (typically 12-24 months), an independent appraisal is required.
- Advantage: Combines the simplicity of a fixed price with the safety net of an appraisal.
- Risk: Requires discipline to maintain the annual valuation process.
Valuation Discounts and Premiums
For closely held businesses, valuation often involves discounts for lack of marketability (the interest cannot be sold on a public exchange) and lack of control (a minority interest has limited governance power). The buy-sell agreement should address whether these discounts apply, because they can reduce the buyout price by 20-40%.
There is an inherent tension here. The departing owner wants full fair market value. The remaining owners want discounts applied. Resolving this question in advance, when everyone is negotiating in good faith, is far better than litigating it after a trigger event.
IRS Scrutiny of Buy-Sell Valuations
The IRS does not automatically accept the valuation in a buy-sell agreement for estate or gift tax purposes. Under IRC section 2703, the IRS can disregard a buy-sell restriction if:
- It is not a bona fide business arrangement
- It is a device to transfer property for less than full and adequate consideration
- Its terms are not comparable to similar arm’s-length arrangements
Buy-sell agreements among family members receive heightened scrutiny. The agreement must reflect genuine business purposes and market-rate terms to withstand challenge.
Funding the Buyout
The best buy-sell agreement in the world is worthless if the buyer cannot pay. Funding is the operational backbone of the agreement.
Life Insurance
Life insurance is the most common funding mechanism for death-triggered buyouts. The proceeds provide immediate cash to complete the purchase.
Cross-purchase insurance. Each owner holds a policy on the life of every other owner. When an owner dies, the surviving owners receive the proceeds and use them to buy the deceased owner’s interest.
Entity-owned insurance. The company holds and pays premiums on a policy for each owner. When an owner dies, the company receives the proceeds and uses them to redeem the deceased owner’s interest.
After Connelly: Business owners with entity-owned life insurance should review their buy-sell agreements with counsel. The Supreme Court’s 2024 holding that entity-owned insurance proceeds inflate company value for estate tax purposes may make cross-purchase or hybrid structures more tax-efficient, depending on the owners’ individual estate tax situations.
Disability Insurance
Disability buyout insurance covers the scenario where an owner becomes permanently disabled. These policies typically have a waiting period (often 12-24 months) before benefits are payable, so the buy-sell agreement should define the disability trigger consistently with the insurance policy.
Installment Payments
For voluntary departures (retirement, resignation), installment payments allow the buyer to pay over time, often 3-7 years, with interest. The agreement should specify:
- The down payment amount
- The interest rate (or a formula tied to a benchmark rate)
- The payment schedule
- Security for the unpaid balance (often a promissory note secured by the purchased interest)
- Acceleration provisions in the event of default
Company Cash Flow
Some businesses fund buyouts from operating cash flow without insurance. This works for smaller buyouts but creates strain if the buyout amount is large relative to the company’s cash position. A company-funded buyout also reduces the working capital available for operations during the transition period.
Sinking Fund
A sinking fund is a reserve account the company builds over time specifically to fund future buyout obligations. This approach spreads the financial impact over years rather than concentrating it at the time of the trigger event. The practical challenge is that most growing businesses prefer to reinvest cash rather than set it aside.
Coordination with Other Documents
A buy-sell agreement does not operate in isolation. It must coordinate with several other documents to function properly.
Operating Agreement or Bylaws
The buy-sell agreement’s transfer restrictions must be consistent with the operating agreement (LLC) or bylaws (corporation). Conflicting provisions create ambiguity that invites litigation. Many practitioners include the buy-sell provisions directly in the operating agreement rather than drafting a separate document, which eliminates the coordination problem entirely.
Estate Planning Documents
The buy-sell agreement must coordinate with each owner’s will, trust, and power of attorney. If an owner’s trust holds their business interest, the trust must authorize the trustee to comply with the buy-sell agreement’s terms. An estate plan that conflicts with the buy-sell agreement can delay the buyout and trigger litigation between the company and the deceased owner’s estate.
Employment Agreements
If an owner is also an employee, the employment agreement’s termination provisions should be consistent with the buy-sell agreement’s trigger events. Termination of employment is often a trigger event, and the terms of the buyout should account for any severance or compensation obligations.
Insurance Policies
The insurance coverage amounts, policy ownership, and beneficiary designations must align with the buy-sell agreement’s terms. Review these annually. A common failure point: the buy-sell agreement assumes a $2 million buyout, but the insurance policy was purchased at $1 million years ago and never updated.
Common Mistakes Minnesota Business Owners Make
Not having one at all. This is the most common and most dangerous mistake. Without a buy-sell agreement, a partner’s death, divorce, or departure triggers a scramble governed by default statutory rules that may not match anyone’s expectations.
Setting the price once and forgetting it. A buy-sell agreement with a 2018 valuation in a company that has tripled in revenue is a lawsuit waiting to happen.
Mismatching insurance and buyout obligations. The insurance coverage must keep pace with the company’s value. Review both annually.
Ignoring the tax consequences. The choice between cross-purchase and entity redemption has real dollar implications for both the departing owner’s estate and the remaining owners’ future tax liability. After Connelly, this analysis is more important than ever.
Using a template without customization. Buy-sell agreements involve entity-specific, state-specific, and fact-specific analysis. A generic template downloaded from the internet cannot account for Minnesota’s LLC statute, state estate tax thresholds, or the specific dynamics of your ownership group.
Failing to address disability. Death gets all the attention, but permanent disability is statistically more likely during working years and creates a more complex situation. A disabled owner may have ongoing financial needs that a lump-sum buyout does not fully address.
When to Create or Update Your Buy-Sell Agreement
If you do not have a buy-sell agreement, the time to create one is now, while all owners are healthy, cooperative, and able to negotiate in good faith. Once a trigger event occurs, the opportunity for orderly planning has passed.
If you already have a buy-sell agreement, review it in response to any of these events:
- Change in ownership. A new partner joins, or an existing partner leaves.
- Significant change in company value. Revenue doubles, a major contract is signed, or the company acquires another business.
- Change in tax law. The Connelly decision in 2024 is a prime example. If your agreement relies on entity-owned insurance, the estate tax implications have changed.
- Change in personal circumstances. Marriage, divorce, birth of children, or changes in an owner’s health status.
- Annual review. Even without a specific triggering event, an annual review ensures the valuation, insurance coverage, and terms remain current.
Frequently Asked Questions
Is a buy-sell agreement legally required?
No. Minnesota law does not require business owners to have a buy-sell agreement. But the default rules that apply without one rarely produce the outcome any owner would choose. The question is not whether you need one, but how much risk you are comfortable accepting without one.
Can a buy-sell agreement override Minnesota’s default LLC rules?
Yes. Under Chapter 322C, the operating agreement (which can include buy-sell provisions) can override most of the statute’s default provisions regarding transfer, dissociation, and dissolution. This is one of the primary purposes of a buy-sell agreement.
What happens if we cannot agree on a valuation?
This depends on the dispute resolution mechanism in your agreement. Well-drafted agreements include a process: first, the parties attempt to agree; if they cannot, an independent appraiser is engaged; if the parties disagree with the appraiser’s conclusion, the agreement may provide for a panel of appraisers or arbitration. The key is building the dispute resolution process into the agreement before a dispute arises.
How much does a buy-sell agreement cost?
The legal fees for drafting a buy-sell agreement vary depending on the complexity of the ownership structure, the number of owners, and the specific provisions required. The cost is a fraction of what it costs to litigate an ownership dispute without one.
After Connelly, should I switch from entity redemption to cross-purchase?
It depends on your specific facts. Connelly affects the estate tax treatment of entity-owned life insurance, but estate tax is only one factor. The right structure depends on the number of owners, their relative ownership percentages, their individual estate tax situations, the entity type (C corp, S corp, LLC), and the available funding options. This is a decision that warrants analysis with both legal counsel and a tax advisor.
For guidance specific to your situation, contact Aaron Hall, Attorney for Business Owners at 612-466-0040.