Economic Evaluation Group, Inc.

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CROSS PURCHASE BUY-SELL AGREEMENT

A buy-sell agreement obligates one party to purchase a deceased business owner's interest at a certain price, and another party-the deceased owner's estate or heirs-is obligated to sell the interest at that price. Under a cross-purchase type of buy-sell agreement, each business owner individually agrees to buy a portion of a deceased owner's interest. Under another type, the entity buy-sell agreement, the business entity itself, not the individual owners, agrees to buy the interest.

A buy-sell agreement gives business owners certainty about who will purchase a deceased owner's interest, what the price will be, when the sale will take place, and where the funds will come from. To fund a cross-purchase buyout, each owner purchases a life insurance policy covering the life of every other owner. The total amount of insurance approximates the purchase price for the insured's share of the business. The purchase price is either specified as a certain, fixed amount, or the agreement includes a formula to be used to establish the price.

Assume three partners own equal shares in a business. Each owner's share is valued at $100,000.

  • - Owner #1 and Owner #2 each purchase a $50,000 policy covering Owner #3.
  • - Owner #2 and Owner #3 each purchase a $50,000 policy covering Owner #1.
  • - Owner #1 and Owner #3 each purchase a $50,000 policy covering Owner #2.

 

Each business owner/partner owns the policies he or she buys covering the lives of the others, and is the beneficiary of those policies. If an owner dies, the surviving owners use the life insurance proceeds to purchase the deceased owner's interest.

Cross-purchase agreements generally provide that the ownership interest of each surviving business owner remains the same in relation to the other owners. So, if the relationships are unequal, they remain unequal after the death. For example, Ash owns 60%, Birch owns 30% and Cedar owns 10%. If Cedar dies, Ash's interest is still twice that of Birch:

Present Position Position after Cedar's Death
Ash 60% 66-2/3%
Birch 30% 33-1/3%
Cedar 10% ----------

Premiums paid personally by each owner are not tax-deductible. A business corporation that pays the premiums on behalf of shareholder-employees may be able to deduct the premiums as reasonable and necessary compensation. The shareholder-employees must report these amounts as income. Policy proceeds are generally received federal income tax free, subject to rules regarding transfer of policies for a valuable consideration. Surviving owners receive a step-up in basis under a cross-purchase agreement that is not available in an entity or stock redemption agreement. A step-up is desirable because it reduces the amount of taxable capital gain upon a future sale of the business interest. Any cash value in policies the deceased person owns covering the other business owners is included in the deceased owner's estate, and thus could affect the estate tax payable.

Some reasons why a cross-purchase agreement may not be attractive include:

  • - If a business has many owners, a cross-purchase agreement can be cumbersome. For example, with six owners, each owner purchases a policy covering the other five, for a total of 30 life insurance policies to fund the agreement.
  • - If there is a wide disparity in the owners' ages, the younger owners carry the greater premium-payment burden since the older owners' policies cost more.
  • - The business itself cannot use the cash values that might accumulate in the policies since the individuals, not the business entity, own the policies.

 

To avoid the multiple policy problem, owners may use a "trusteed" cross-purchase agreement.

  • - The trustee acquires and owns life insurance on each owner, reducing the number of policies to the number of owners.
  • - The trustee collects the policy proceeds when an owner dies, pays the proceeds to the deceased owner's estate, and transfers the deceased owner's shares to the surviving owners in the appropriate proportions.

 

The price established for a business interest in a buy-sell agreement can fix the value for federal estate tax purposes if strict legal requirements are met. This price can be based on a professional appraisal or formula that takes into account, among other things:

  • - The earnings history and future earnings potential of the business
  • - The book value of the company's assets and the general financial condition of the business
  • - Any prior sales of interests in the business.
  • - Goodwill, and
  • - The outlook for the economy in general and for the specific industry.

 

 

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Economic Evaluation Group, Inc.

© 2016 Economic Evaluation Group, Inc.

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Economic Evaluation Group, Inc. Specializes in Group Health Insurance (Group Medical Insurance). EE Group is located in Melville, Long Island, New York and service all over the United States and Canada.

 

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