Cross Purchase
P&C FINANCIAL AND INSURANCE SERVICES, INC.
What is a Cross-Purchase Agreement?
A cross-purchase agreement is a tool used by business owners to assure that
"business as usual" continues if co-owner dies. Like an entity or stock redemption
agreement, the cross-purchase buy-sell agreement stipulates that—
• a deceased owner's estate must sell the business interest to surviving owners, and
• the surviving owners will buy that interest.
There are no exceptions—the estate must sell and the survivors must buy.
A cross-purchase agreement also establishes the price to be paid for the deceased
owner's business interest. The price is based on: (1) a definite fixed amount stated in
the agreement; or (2) a formula by which a definite price can be established. Current
tax law has made the second method the more prudent choice in recent years.
Purpose of the Cross-Purchase Buy-Sell Agreement
Two concepts stand at the root of all cross-purchase buy-sell agreements: protection
and fairness. A surviving business owner wants to be protected from interference by outsiders when a co-owner dies. Concurrently, a business owner wants to
assure fair treatment of his or her heirs in the event of death.
Shareholders and partners use cross-purchase agreements in the same way corporations and partnerships use entity or stock redemption agreements. The
distinguishing factor is that, with a cross-purchase agreement, each owner buys a policy on the life of every other owner. Under an entity or stock redemption
agreement, the business itself owns a policy on each owner.
Regardless of whether the buyout is cross-purchase, entity, or stock redemption, a properly drafted buy-sell agreement:
• minimizes the possibility that the business might fall into the hands of outsiders
• minimizes the possibility that the parties involved will not be able to agree on a value for the business at the death of an owner
• provides the deceased owner's estate with a ready purchaser for the business interest.
A cross-purchase agreement helps to protect everyone's financial interests, business owners and heirs alike. And funding the agreement with life insurance helps
to provide a secure foundation for the agreement.
How the Cross-Purchase Agreement Works
Assume Grant, Lee and Jackson are equal partners in a business with a total value of $450,000, which means each has an interest of $150,000. Under a crosspurchase agreement, agreements are made that at the death of any partner, the other two will purchase his or her interest from the estate.
In our example, Grant and Lee would each purchase a $75,000 face amount policy on the life of Jackson. The total insurance in force on Jackson's life, then, is
$150,000—enough to purchase his or her business interest. Similar arrangements are made for each partner.
With a cross-purchase agreement, the individual owners own the policies, pay the premiums, and are named beneficiaries, e.g., Jackson is the insured and
Grant is the owner and beneficiary. At the death of one owner, the surviving owners receive the insurance proceeds and use them to purchase the deceased
owner's interest from his or her estate.
In the example, if Jackson dies, Grant and Lee each pay $75,000 to complete the buy-sell agreement. Then Grant and Lee each own one-half of the business.
Policies Owned by the Deceased Owner
The agreement should also provide for the surviving owners to purchase from the deceased owner's estate the life insurance policies which he or she had owned
on their lives. While other arrangements could be made, it should be noted that transfer-for-value problems could arise for a purchaser if the policies are sold to
anyone other than the insured or the business entity.
Ownership Positions
When an owner dies, the typical cross-purchase agreement provides that the ownership interest of each
surviving owner remains the same in relation to the other owners. For example, if Grant's ownership interest Present
is twice as great as Lee's before Jackson dies, it will still be twice as great after Jackson's death, as shown Ownership Position At Jackson's Death
by the example to the right.
Grant 60%
66-2/3%
After Jackson's death, Grant still has an ownership position twice as great as Lee. However, under a cross- Lee 30%
33-1/3%
purchase agreement, there is the flexibility to change relative ownership positions if the buy-sell agreement is Jackson 10%
—
designed for this purpose. In the above example, it could even be arranged that Lee would purchase all of
Jackson's interest, creating a 60/40 ownership position in favor of Grant. This flexibility is not possible with an entity or stock redemption agreement.
P&C FINANCIAL AND INSURANCE SERVICES, INC.
2211 Michelson Drive, Suite 650
Irvine, CA 90803
Daniel J. Pierro
Phone: 949-930-9409
Fax: 949-242-2975
E-mail: [email protected]
Web: www.PCFIS.com
P&C Financial provides the best
of products and people.
WWW.PCFIS.COM
Insurance, Investments, Retirement & Pension Services
Registered Representative of and Securities Offered Through: Hornor Townsend & Kent, Inc.
9930 Research Drive, Suite 100, Irvine, CA 92618 949-754-1700.
Member FINRA/SIPC
Cross Purchase
P&C FINANCIAL AND INSURANCE SERVICES, INC.
Cross Puchase Agreement (Cont.)
Number of Policies Required
The number of policies required under a cross-purchase agreement may be a factor in determining whether such an agreement is feasible. Since each owner
must purchase a policy on every other owner, the numbers can quickly add up. Where N equals the number of owners, the number of policies required in a cross
-purchase agreement is equal to N x (N - 1). In other words, if there are 6 owners, 30 policies are required (6 x 5 = 30) to avoid a transfer for value (in the case of
a corporation) which would occur if 6 policies are jointly owned and policy ownership shifts after an owner's death.
The "Trusteed" Cross-Purchase Agreement
The owners may use a third party, usually referred to as the "trustee," to carry out their obligations under a cross-purchase agreement.
The trustee typically holds the stock certificates (or other evidences of business ownership), and acquires and owns life insurance on each owner. The policy on
J would be paid for by K, L, and M; likewise, the policy on K would be paid for by J, L, and M; and so on. Thus, the number of policies is limited to the number of
owners when a trustee is used, thus overcoming the problems of (1) a multiplication of policies when several owners are involved in a cross purchase, and (2) a
transfer for value when policies are transferred between co-shareholders.
When J dies, the trustee collects the death proceeds of the policy on J. He or she then transfers J's shares to the surviving owners in the agreed-upon proportions, and pays the prescribed proceeds to J's estate. The "trusteed" cross-purchase agreement has enabled J's family to receive a fair price for his interest, and
the surviving owners to maintain control of the business.
A potential problem arises when shareholders are involved. When a shareholder dies, the surviving shareholders will succeed to the beneficial ownership of the
remaining policies held by the trustee. There has been some speculation that this may be a transfer for value that would cause a forfeiture of the income tax
exemption for death proceeds. This problem does not arise for transferee partners, who enjoy an exemption from the transfer-for-value rule.
Selling the Business Interest
As with the entity or stock redemption agreement, the cross-purchase agreement stipulates that any owner wishing to sell an interest during his or her lifetime
must first offer it to the other owners.
Using Life Insurance to Fund the Agreement
Life insurance is often an appropriate way to help fund a cross-purchase agreement, but this may depend on the health and ages of the owners. Manageable
periodic premium payments can help assure the availability of funds for purchasing a deceased owner's business interest, regardless of when the owner dies. If a
reserve or investment fund is used, it may take years to accumulate an adequate fund.
Premium Payments
Regarding premium payments, with a cross-purchase agreement each owner pays for the policies he or she owns. However, premiums can be burdensome for
younger owners who must pay for policies on older owners who may also have a larger business interest. There are no rules or guidelines that can be applied in
every situation. It may be easier to use an entity or stock redemption agreement so the business itself makes the premium payments.
Split-Dollar Cross Purchase
An owner could insure another owner whose interest he or she is obligated to purchase by means of a split-dollar arrangement. For example, Alpha and Theta
enter into a cross purchase agreement and help fund their respective obligations by obtaining life insurance on each other's life. They enter into split dollar arrangements with their corporation which prescribe a sharing of premiums and death proceeds. Each owner-employee will pay a part of the premium, equal to the
economic benefit of the coverage for that year on the insured co-owner. Under a separate agreement, the corporation could bonus out annually an amount sufficient to cover the taxable economic benefit.
When Theta dies, the insurance company pays part of the death proceeds to the corporation as reimbursement under the terms of the split-dollar arrangement.
The balance of the proceeds are paid to Alpha, who uses them to help purchase Theta's interest from his estate. The IRS issued split-dollar final regs in September 2003.
Income Tax Considerations
Premiums Nondeductible
Personally paid premiums for a cross-purchase agreement are not tax-deductible. If the corporation pays the premiums on behalf of shareholder-employees, the
corporation may be able to deduct the premiums as reasonable and necessary compensation, and the shareholder-employees would report that compensation
as income.
Transfer for Value
Generally, the proceeds from a life insurance policy used to help fund a cross-purchase buy-sell agreement are received income tax-free. But if ownership of a
policy was transferred for valuable consideration, death proceeds may be subject to ordinary income tax under the transfer for value rules. However, the transfer
of a policy to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer
is exempt from the transfer for value rule.
Conspicuously missing from the exempt list are transfers to co-shareholders of the insured. So, in the case of a corporate cross-purchase agreement, any sale
or transfer for consideration of a policy by the estate of a deceased shareholder should be either to the insured or to the corporation to avoid transfer for value
problems later. In the case of a partnership cross-purchase agreement, the estate of a deceased partner should be able to safely sell the policy to the insured,
the partnership, or one of the surviving partners.
P&C FINANCIAL AND INSURANCE SERVICES, INC.
2211 Michelson Drive, Suite 650
Irvine, CA 90803
Daniel J. Pierro
Phone: 949-930-9409
Fax: 949-242-2975
E-mail: [email protected]
Web: www.PCFIS.com
P&C Financial provides the best
of products and people.
WWW.PCFIS.COM
Insurance, Investments, Retirement & Pension Services
Registered Representative of and Securities Offered Through: Hornor Townsend & Kent, Inc.
9930 Research Drive, Suite 100, Irvine, CA 92618 949-754-1700.
Member FINRA/SIPC
Cross Purchase
P&C FINANCIAL AND INSURANCE SERVICES, INC.
Cross Puchase Agreement (Cont.)
If a limited liability company is taxed as a pass-through entity, it may be treated as a partnership and its owners as partners for transfer for value purposes, as
was the case in Ltr. Rul. 9625013 (see also Ltr. Ruls. 9625019, 200120007). But because a private letter ruling can be relied upon only by the party that requested it, this may not always be the case.
Increase in Surviving Owner's Basis
Cross-purchase agreements provide a distinct benefit with regard to a lifetime sale of a business interest. Assume that you own 50% of ZYX corporation, and the
other 50% owner is Jones. You each have a basis of $100,000. When Jones dies, under the terms of your cross-purchase agreement, you purchase his business interest for $200,000. Your basis in the corporation is now stepped-up to $300,000. If you later sell the business for $500,000, you will realize a capital gain
of $200,000.
Under an entity or stock redemption agreement, after purchasing Jones' business interest, your basis would remain at $100,000. Thus, if you later sold your business for $500,000, you would have a capital gain of $400,000. The tax bite would be significantly greater under this arrangement.
This discussion does not apply to a partnership, where an entity purchase would result in an increase in basis for the surviving partners. The surviving shareholders of an S corporation using the cash method of accounting could also receive an increase in basis with a properly drafted buy-sell agreement.
Estate Planning Considerations
A properly drafted cross-purchase agreement may help to establish the value of a deceased owner's business interest for estate tax purposes if specific requirements are met. The key is for the agreement to meet IRS guidelines and approximate the fair market value of the business interest on the date the agreement is
made. Under IRC Sec. 2703, an agreement entered into after October 8, 1990, can establish the value of a closely held business if (1) it is a bona fide arrangement, (2) it is not a device to transfer the business to family members for less than full and adequate consideration, and (3) it has terms comparable to those of
arm's-length transactions.
The accumulated case law has created certain additional rules, which apply even if a particular agreement is not subject to IRC Sec. 2703 (e.g., because it was
executed before October 8, 1990): (4) the estate must be obligated to sell at an owner's death, either under a mandatory agreement, or under an option held by
the business or the surviving owners; (5) the sale price must be fixed by the agreement, either as a dollar amount or by some formula for determining the price;
(6) the agreement must prohibit an individual owner from selling his or her interest during life without first offering it to the business or to the other owners at a
specified price; and (7) the price set in the agreement must have been fair and adequate at the time the agreement was made.
Capital Gains for Heirs
Sale of the deceased owner's interest by the executor will have no adverse income tax consequences because of the stepped-up basis provision (through 2009).
The deceased owner's original basis is automatically stepped-up to its value for estate tax purposes. Thus, the estate usually realizes no capital gain on the
transaction and no income tax is payable.
Stepped-up basis is scheduled to be repealed for one year beginning on January 1, 2010, and then reinstated on January 1, 2011.
A limited step-up is available in year 2010.
Cash Values
The cash values of policies owned by the deceased on the lives of other owners are included in the deceased owner's estate. Large cash value amounts could
have a significant impact on the size of the estate and thus on the estate tax payable.
Alternative Minimum Tax
Since the business does not own the policies used in a cross-purchase agreement, there are no potential corporate alternative minimum tax consequences.
Why Cross-Purchase Agreements Are Used
One factor that sometimes influences the decision to implement a cross-purchase agreement is that there will be no alternative minimum tax consequences.
Thus, if shareholders of a corporation are concerned about preference income and potential tax liabilities, a cross-purchase agreement may be preferred. In
addition, the stepped-up basis for surviving owners is an important consideration if owners perceive the likelihood of a lifetime sale of a business interest.
Buy-sell agreements funded with life insurance can be pivotal to the success of a business. The surviving business owners (as well as a deceased owner's estate) receive funds precisely when they are most needed. As an insurance professional, it is your responsibility to work with the client's legal counsel and to know
the unique features of each type of buy-sell arrangement to help prepare you to meet each client's needs.
P&C FINANCIAL AND INSURANCE SERVICES, INC.
2211 Michelson Drive, Suite 650
Irvine, CA 90803
Daniel J. Pierro
Phone: 949-930-9409
Fax: 949-242-2975
E-mail: [email protected]
Web: www.PCFIS.com
P&C Financial provides the best
of products and people.
WWW.PCFIS.COM
Insurance, Investments, Retirement & Pension Services
Registered Representative of and Securities Offered Through: Hornor Townsend & Kent, Inc.
9930 Research Drive, Suite 100, Irvine, CA 92618 949-754-1700.
Member FINRA/SIPC