Buy-Sell Agreements: The Tax Trap Most Partners Overlook

A buy-sell agreement is one of the most important documents for a business with multiple owners. It can establish what happens when a partner dies, becomes disabled, retires, leaves the company, or otherwise needs to sell an ownership interest.

From a business perspective, the purpose seems straightforward: establish a mechanism for one owner or the company to purchase the departing owner’s interest.

The tax consequences, however, are not always straightforward.

The agreement may determine who buys the interest, how the purchase is funded, how the price is determined, and when the transaction occurs. Those decisions can affect the tax treatment for both the departing owner and the remaining owners.

For partnerships and other pass-through businesses, the tax analysis can become particularly complicated because the tax result may depend not only on the purchase price, but also on the seller’s basis, the assets owned by the business, liabilities, and the character of the assets underlying the ownership interest.

A buy-sell agreement that has never been reviewed from a tax perspective may therefore create an unexpected problem at exactly the time the owners need the agreement to work.

What Is a Buy-Sell Agreement?

A buy-sell agreement is a contract among business owners, or between the owners and the business, that establishes rules for transferring ownership interests under specified circumstances.

Depending on the business, it may address events such as:

• Death of an owner
• Retirement
• Disability
• Voluntary departure
• Involuntary departure
• Bankruptcy
• Divorce or other ownership disputes
• An owner’s desire to sell an interest
• Certain changes in control

The agreement may also establish a valuation method and identify who has the right or obligation to purchase the departing owner’s interest.

That structure can provide important business continuity. But the agreement should not be viewed only as a legal document. Its provisions can have significant tax implications.

The Tax Issue Hidden Behind the Purchase Price

One of the most commonly overlooked issues is that the amount paid for an ownership interest is not necessarily the same thing as the seller’s taxable gain.

For a partnership interest, the seller’s gain or loss generally depends on the amount realized compared with the partner’s adjusted basis in the partnership interest. The IRS also notes that certain liabilities can be included in the amount realized when a partner is relieved of partnership liabilities.

That means two owners could potentially receive similar purchase prices but have very different tax consequences.

The seller’s historical investment in the business, prior allocations, distributions, debt, and other factors may affect basis.

A buy-sell agreement that focuses exclusively on determining a fair purchase price may therefore leave an important part of the transaction unaddressed.

Not All Partnership Gain Is Necessarily Capital Gain

Another important issue arises from the assets owned by the partnership.

A sale of a partnership interest is generally treated as a capital transaction, but the tax law contains important exceptions for certain partnership assets, including unrealized receivables and inventory items.

Under Section 751, amounts attributable to certain “hot assets” can be treated as ordinary income rather than capital gain. The IRS requires partnerships to report qualifying transactions and provides Form 8308 for certain sales or exchanges of partnership interests.

This distinction can matter significantly when the business has accumulated receivables, inventory, or other assets that do not receive the same tax treatment as a long-term investment asset.

In other words, the tax result of buying or selling a partnership interest cannot always be determined simply by taking the purchase price and subtracting the owner’s original investment.

The Agreement’s Valuation Formula Can Create Tax Problems

Many buy-sell agreements contain a valuation formula.

That may be a fixed dollar amount, a formula based on revenue or earnings, a book-value approach, an appraisal requirement, or another agreed methodology.

A formula can provide certainty among owners, but there is an important distinction between a contractual purchase price and a tax valuation. A value that was reasonable when the agreement was drafted may become outdated as the company grows.

For example, a business might have been worth $4 million when its owners signed the agreement. Several years later, the company could be worth $12 million.

If the agreement still relies on an old formula or an unrealistic valuation mechanism, the resulting purchase price may no longer reflect the economic reality of the business. That can create financial and tax issues for both the departing owner and the remaining owners.

Cross-Purchase vs. Entity Purchase

The structure of the buy-sell agreement also matters.

In a cross-purchase arrangement, the remaining owners generally purchase the departing owner’s interest directly. In an entity-purchase arrangement, the business itself purchases the departing owner’s interest.

These structures can produce different legal, financial, and tax consequences.

The difference becomes especially important when life insurance is used to provide liquidity following an owner’s death. The ownership of the insurance policies, the beneficiary arrangements, the amount of coverage, and the way the purchase is structured should all be considered together rather than treating the insurance policy as a separate issue.

Life insurance proceeds paid because of the insured’s death are generally excluded from income under federal tax rules, subject to applicable exceptions. That does not mean every buy-sell structure funded with insurance produces the same overall tax result.

The agreement, ownership structure, insurance arrangement, and tax reporting need to work together.

Basis Can Become a Major Issue for the Buyer

The tax analysis does not stop with the departing owner.

The purchasing owner can also have important tax considerations.

The purchaser’s tax basis in the acquired partnership interest generally reflects the cost of the interest, but the tax basis of the partnership’s underlying assets may not automatically change simply because an ownership interest changes hands. A Section 754 election may allow or require certain basis adjustments under applicable circumstances.

This is one of the areas where a transaction that appears simple on paper can become much more complicated from a tax perspective.

The buyer may be focused on the cash required to acquire the interest, while the CPA needs to consider what happens to the buyer’s tax basis and the underlying partnership assets after the transaction.

The details depend heavily on the entity and transaction structure.

What Happens When an Owner Dies?

Death is one of the most common events addressed by a buy-sell agreement.

The agreement may require the surviving owners or the company to purchase the deceased owner’s interest, often using life insurance to provide liquidity. But the death of an owner creates several issues simultaneously.

There may be:

• A valuation of the ownership interest
• An estate holding the ownership interest
• Insurance proceeds
• A purchase obligation
• Tax basis considerations
• Partnership or corporate tax reporting
• Potential estate-tax considerations
• Questions about the timing of the transaction

These issues should be coordinated.

A buy-sell agreement that works well as a business-continuity document may still need a separate review to determine whether its tax provisions remain appropriate.

The Agreement May Be Years Out of Date

This is one of the most common practical problems.

Owners create a buy-sell agreement when the company is relatively small. Years later, the business has changed substantially.

Revenue has increased. New partners have joined. Ownership percentages have changed. The company has acquired real estate or other assets. Debt has increased or decreased. The owners’ personal circumstances have changed.

Meanwhile, the original buy-sell agreement may still contain the same valuation formula and assumptions. A document does not necessarily remain appropriate simply because it is still legally valid.

Business owners should consider reviewing the agreement when there has been a significant change in ownership, value, financing, business structure, or succession plans.

Tax Planning Should Be Part of the Process

The best time to discover a tax problem in a buy-sell agreement is before the agreement is needed.

Once a partner has died, retired, or decided to leave the business, the parties may have limited flexibility. At that point, the agreement may already determine the purchase mechanism and valuation procedure.

A proactive review can instead examine whether the agreement is consistent with the company’s current structure and whether the tax consequences have been considered. This does not mean that the CPA replaces the attorney who drafts the agreement.

The legal agreement and the tax analysis serve different purposes and should work together.

Warning Signs That a Buy-Sell Agreement Needs Review

Business owners may want to have their agreement reviewed when:

• The company has grown substantially since the agreement was signed.
• The ownership percentages have changed.
• A new partner has joined the business.
• A partner has retired or is approaching retirement.
• The company has acquired significant new assets.
• The business has taken on substantial debt.
• The valuation formula has not been updated.
• Life insurance policies used to fund the agreement have changed.
• The company’s legal entity has changed.
• The owners have not reviewed the tax consequences with their CPA.
• The agreement was drafted years ago and has never been reviewed.

Any one of these circumstances may justify a closer look.

Why the CPA Review Matters

A buy-sell agreement sits at the intersection of business ownership, valuation, financing, insurance, and taxation.

The attorney may focus on enforceability and legal rights. The insurance professional may focus on funding. The business owners may focus on continuity and fairness.

The CPA brings another perspective: what happens for tax purposes when the agreement is actually triggered?

That analysis can involve basis, gain recognition, ordinary-versus-capital treatment, partnership liabilities, asset composition, reporting requirements, and the tax consequences to both sides of the transaction.

The earlier these issues are identified, the more options the owners may have for addressing them.

Final Thoughts

A buy-sell agreement is designed to provide certainty during some of the most uncertain moments in a business.

But certainty about who buys an ownership interest and how much they pay does not necessarily mean certainty about the tax consequences.

For partnerships and closely held businesses, the tax result can depend on factors that are not obvious from the agreement itself. The owner’s basis, partnership liabilities, underlying assets, valuation, transaction structure, and applicable tax rules can all affect the outcome.

That is why a buy-sell agreement should not be treated as a document that only needs to be reviewed when a partner is ready to leave.

A periodic tax review can help business owners identify potential problems while there is still time to address them.

Need Help Reviewing the Tax Side of Your Buy-Sell Agreement?

If your business has multiple owners, a buy-sell agreement should be evaluated not only for legal and business purposes, but also for its potential tax consequences.

For more information about our tax planning and tax compliance services, contact Velin & Associates, Inc. today.

Velin & Associates, Inc.

8159 Santa Monica Blvd STE 198/200
West Hollywood, CA 90046
📞 323-902-1000
📧 dmitriy@losangelescpa.org

We work with business owners and closely held companies on tax planning, entity issues, ownership changes, and complex transactions.

This article is for general informational purposes only and does not constitute legal, tax, or financial advice. The tax treatment of a buy-sell transaction depends on the specific facts, entity structure, agreement, ownership interests, and applicable tax rules. Business owners should consult qualified legal and tax professionals before entering into or modifying a buy-sell agreement. CPA for YouTubers | CPA for Shopify Store | CPA for Commerce | CPA for Creators | Shopify Store CPA | CPA for Filmmakers | CPA for Amazon Business | Amazon Business CPA | CPA for Dental Practice | Dentist CPA | Dental Business CPA | Online Commerce CPA | CPA for Doctors | CPA for Medical Practice | CPA for High Net Worth Individuals | Tax Services Healthcare | Tax Services for a Business | Tax Services TikTok | Tax Services for Commerce | Tax Services Los Angeles | Bookkeeping and Tax Services | Tax Preparation | Accounting Firm | Tax Services for Doctor | Tax Services for Entertainment | Online CPA | CPA Los Angeles