Are Buy Sell Agreements Tax Deductible?

A buy-sell agreement creates a clear plan for what happens to a business owner’s share if certain events occur. This legal contract ensures a smooth transfer of ownership when an owner leaves the business due to situations like death, disability, retirement, or divorce. Its main purpose is to maintain business stability, prevent disputes among remaining owners, and ensure the business continues operating. It also helps ensure the departing owner or their estate receives fair value for their interest.

Tax Deductibility of Establishment and Maintenance Costs

The costs incurred to establish, review, or amend a buy-sell agreement are not deductible as ordinary business expenses. These expenses often include legal fees for drafting the agreement, accounting fees for valuation assistance, and other professional service charges. The IRS views these costs as capital expenditures rather than deductible operating expenses.

When costs are capitalized, they are added to the basis of the ownership interest. This means the expenses are not deducted in the year they are paid but instead reduce any taxable gain or increase any deductible loss when the ownership interest is eventually sold. If an agreement primarily benefits individual shareholders rather than the business entity, some related costs may be considered non-deductible personal expenses. Maintaining or updating an existing buy-sell agreement follows similar non-deductibility rules.

Tax Implications of Funding Mechanisms

Buy-sell agreements often use specific funding mechanisms, each with distinct tax implications. Life insurance is a common choice, where premiums paid for policies funding these agreements are not tax-deductible by the payer, whether it is the business or individual owners. This non-deductibility applies because the death benefit is received tax-free by the beneficiary under IRC Section 101.

Cash value growth within life insurance policies accumulates on a tax-deferred basis. This means taxes are not paid on the annual increase in value until funds are withdrawn or the policy is surrendered. Withdrawals from a policy are tax-free up to the amount of premiums paid, and policy loans are tax-free. However, if a policy is surrendered and the cash value exceeds the total premiums paid, the excess amount becomes taxable as ordinary income.

Other funding methods also have specific tax treatments. A sinking fund, where the business or owners set aside money, involves non-deductible contributions. Any interest earned on the funds held in this account is taxable as ordinary income to the entity or individual holding the account. Similarly, principal payments made by the buyer for installment payments to the departing owner are not deductible expenses. However, any interest paid on these installments may be deductible for the payer, such as business interest under IRC Section 163 for businesses, and is taxable as ordinary income to the recipient.

Tax Treatment of the Sale or Purchase

When a buy-sell agreement is triggered and an ownership interest is transferred, the transaction results in a capital gain or loss for the seller. The seller’s tax liability depends on the difference between the sale price and their adjusted cost basis in the ownership interest. The adjusted basis includes the original purchase price, capital contributions, and adjustments for undistributed earnings or losses in pass-through entities. The holding period of the interest (short-term or long-term) determines the applicable tax rates.

Short-term capital gains are taxed at ordinary income tax rates, which can be as high as 37% for the highest income brackets in 2025. Long-term capital gains are subject to preferential rates (0%, 15%, or 20%), depending on the seller’s taxable income. High-income individuals may also be subject to the 3.8% Net Investment Income Tax (NIIT) under IRC Section 1411 on net investment income, including capital gains from the sale of a business interest.

The character of the gain or loss can also be influenced by the type of business entity. For sellers of C-corporation stock, the gain or loss is treated entirely as capital. For S-corporation stock, the sale results in a capital gain or loss, but the owner’s basis adjustments for pass-through income and losses are important. Selling an interest in a partnership or a multi-member LLC taxed as a partnership can be more complex. A portion of the gain may be recharacterized as ordinary income if the partnership holds “hot assets” (unrealized receivables or inventory) under IRC Section 751.

For the buyer, the purchase price paid for the ownership interest is not a deductible expense in the year of the acquisition. Instead, this payment establishes their cost basis in the newly acquired interest, under IRC Section 1012. This basis is important for future tax calculations, such as determining gain or loss if the buyer later sells the interest. The basis may also be used for depreciation or amortization if the acquisition is structured as an asset purchase rather than a stock purchase.

Valuation and Other Tax Considerations

The valuation of a business interest within a buy-sell agreement plays a significant role in determining the tax consequences for the seller. The agreed-upon price directly influences the amount of capital gain or loss recognized when the agreement is triggered. Establishing a fair market value (FMV) for the business interest is important to avoid scrutiny from the IRS. If the sale price is significantly below FMV, the IRS could view the difference as a deemed gift, potentially triggering gift tax implications under IRC Section 2512.

Various valuation approaches exist, including asset-based, income-based, and market-based methods, which aim to determine FMV. Their proper application is necessary to support the sale price for tax purposes. An independent valuation by a qualified professional can provide documentation to substantiate the transaction price if questioned by tax authorities.

Beyond the immediate sale, buy-sell agreements can have other tax implications. These agreements were used to fix the value of a business interest for estate tax purposes. Under IRC Section 2703, for an agreement to be respected for estate tax valuation, it must be a bona fide business arrangement, not a device to transfer property to family members for less than full consideration, and its terms must be comparable to arm’s-length transactions. Owners should also consider how their interest might be treated under passive activity rules, under IRC Section 469. This can affect the deductibility of losses if the owner is not materially participating in the business. Capital gains from the sale of an ownership interest can also impact Alternative Minimum Tax (AMT) calculations, potentially increasing overall tax liability.