Complete Overview of Cross Purchase Buy-Sell Agreements
There are several ways to structure a buy-sell agreement and each has its advantages and disadvantages, but one goal remains the same: to ensure that the ownership of a closely held business will be transferred smoothly to continue on within the remaining partners.
The most common type of buy-sell agreement is the cross purchase agreement. These agreements bring provisions into play as a business owner dies, becomes disabled, or exits during other circumstances. Cross purchase agreements work by requiring that, upon the death, disability, or exit of a business owner, their ownership interest is purchased from the estate or from the departing owner by the remaining owners . For instance, if there are four closely held business owners and if one of the owners dies, the remaining three partners will have the option to purchase the business interest of their deceased partner. Each will normally have the right to acquire one-third of the business interest of the deceased partner.
Many think buy-sell agreements only come into place upon the death of a business owner. In fact, however, a buy-sell agreement can come into play during other times as well, such as upon the exit of a business owner, upon disability, or during other specified events.
Advantages of a Cross Purchase Arrangement
One of the advantages offered by cross purchase arrangements is that each owner enters into every buy-sell contract with no conflicting interests. If an owner wishes to buy, the proceeding owner will be inclined to sell; conversely, if the selling owner would like to get out of the business, they may buy the other owner out. A cross purchase agreement also provides the advantage of easier funding. Life insurance is commonly used to fund these agreements. The cash value of a life insurance policy can be drawn upon without taxation as a loan. The tax issues associated with cashing in life insurance are handled differently than for other investments, and since life insurance can be spread over the lifetimes of both spouses, owners are able to buy a policy with lower rates. Finally, life insurance proceeds themselves are not subject to income tax if properly set up, avoiding five different forms of tax. Cross purchase arrangements are suited for closely held businesses. Corporations and professional practices usually require separate buy-sell agreements if their corporate existence is to remain intact. For health professionals, corporations offer liability protection that otherwise is not permissible for unincorporated practices. Fair valuation is another benefit of a cross purchase arrangement. The valuation of a business is one of the most important components of a buy-sell agreement, regardless of the form chosen; however, a common issue is whether the value of the business at the time of the buyout is fair to the remaining owners. To avoid complications, it is advisable to have a current valuation done by a third party business valuator.
Cross Purchase and Entity Purchase Buy-Sell Agreements Compared
In a Cross Purchase Buy-Sell Agreement, the purchasing shareholders, partners, or members buy or redeem the stock or membership units of the deceased or withdrawing owner directly from his or her estate or heirs. In contrast, in an Entity Purchase (or Redemption) Buy-Sell Agreement, the corporation, LLC, or partnership itself buys the deceased, retiring, or withdrawing owner’s interest. There are advantages and disadvantages to each kind of agreement.
A Cross Purchase Buy-Sell Agreement is more attractive to the owners. When the owners buy from "outsiders" (the estate and heirs of the deceased owner), they do not have to pay funds into an escrow fund to help assure the availability of cash for the purchase. If the company buys the deceased owner’s interest, the company may be obliged to use its earnings for the purchase, which could leave too little working capital to run the business. Or, the company’s purchase could trigger tax liabilities that result in sacrificing a distribution that would otherwise have been paid to the shareholders, partners, or members. Neither result is satisfactory.
In addition, the owners can usually wait to make payments for the purchased owner’s interest until the business has prospered to the point that earnings are available for distributions to pay for the interest. In contrast, the company must either squeeze out a distribution or find other cash to buy the deceased owner’s interest from his or her estate or heirs.
Because both the estate or heirs and the purchasing owners want to know the purchase price, a Cross Purchase Buy-Sell Agreement should have the decedent’s and each surviving owner’s agreement on the purchase price. A deceased owner’s estate is much more likely to agree on the price of his or her interest if she or he already agreed, before death, to the price at which surviving owners are obligated to buy his or her interest.
The drawbacks of a Cross Purchase Buy-Sell Agreement include:
In an Entity Purchase (or Redemption) Buy-Sell Agreement, the company buys the deceased or withdrawing owner’s interest. Usually, the corporation pays for the interest with life insurance proceed (if the company owns the policy), company earnings from funds not distributed as profits, or borrowed funds.
The company has certainty because it buys the interest of the deceased or withdrawing owner, not the interests of his or her estate or heirs. Since the company’s liabilities were not paid first, funds are available to pay the purchase price without harming the company’s necessary working capital. Depending on how the agreement is structured, the purchase price may not have to be determined until the owners die or retire.
The purchase agreement should describe how the purchase price will be determined after the price is due. This can be done in several ways, including:
The drawbacks of an Entity Purchase (or Redemption) Buy-Sell Agreement include:
In summary, both entities (cross purchase and entity purchase (or redemption) buy-sell agreements) are legally acceptable, although Cross Purchase Agreements are used somewhat more frequently than Entity Purchase (or Redemption) Buy-Sell Agreements.
Setting Up a Cross Purchase Agreement
Generally, entering into a cross purchase buy-sell agreement involves the following steps:
- . Draft and review an agreement with advisers to ensure it meets all legal and financial requirements, considering factors such as valuation, the sale of interest in an LLC (limited liability company), and taxes. Business owners typically seek advice from their accountants, business attorneys, estate planning attorneys, and insurance specialists, as necessary.
- . Inventory the interests that will be covered by the agreement and determine who will need to acquire a particular interest in the event of a trigger event.
- . Determine how and when the business will be valued and who will pay the premiums on any policies used to fund the agreement. For example , one company might pay the premiums but one or more of the companies might reimburse that company directly. Alternatively, the owners might pay the premiums individually and then be reimbursed from the profits of the company or through entity funds.
- . Each owner should begin to work with its insurance adviser to identify how best to fund the agreement and make sure the owners can qualify for nontaxable life insurance, assuming that is part of the funding solution.
- . Put the policies in place as soon as possible so there are no gaps in coverage between the contract execution and the trigger event.
- . Review the agreement and the policies regularly to ensure they continue to reflect the business’s changing needs and applicable laws.
Tax Treatment of Cross Purchase Agreements
Cross purchase buy-sell agreements can have a number of tax advantages. For example, if the corporation compensates the deceased owner’s heirs or beneficiaries in the form of an interest in the business after death, it can generally deduct all payments made to the estate or heirs under the terms of the agreement, even if the payments exceed the value of the stock transferred to them. If the deceased shareholder had left his shares to his spouse or some other person, it is possible that the corporation would be required to capitalize the payments and depreciate them over the life of the asset.
For stock owned by a sole proprietor or by partners, a cross purchase buy-sell agreement is treated as a disposition on death, just as an agreement to sell improves liquidity for the seller. If the decedent sells the property to a surviving spouse or a partner, it may be treated as a gift or a dividend to the extent of the stock value or the cash equivalent of the consideration received.
On the other hand, such agreements may also have tax liabilities for the beneficiary. As part of the deceased’s gross estate, the fair market value of the life insurance policy on each of the business owner’s life is included in the owner’s taxable estate for estate tax purposes, even though the proceeds of the policy are distributed at the owner’s death to the other owners of the business unit. If the business owners agree to use the funds to purchase the decedent’s interest in the entity, he or she is generally entitled to a prodata share of the death benefit. Only the amount of the death benefit received directly by the decedent’s estate may be excluded from gross estate tax.
Common Issues & Solutions
In addition to figuring out who will own and control the business after an event, purchase agreements require agreement on purchase price, terms of payment, and source of financing. Thus, a corporation issuing stock or a partnership entity will likely impose additional requirements and impose additional conditions in order to finance the deal.
Any cross purchase buy-sell arrangement is dependent on the extrinsic value of any insurance. The need for insurance coverage, the available financial resources to cover the insurance premium, and the resulting additional costs to the company should also be factored into an evaluation of the different options available for a cross purchase agreement.
In some cases, a buyer’s insurance coverage may be reduced by a preexisting condition. Although this risk can be managed by implementing a waiting period for newly acquired partners or employees , the waiting period adds time to a process that already takes years to implement. In addition to considering the effects of a waiting period on the waiting business relationship, a business may consider acquiring permanent or convertible term insurance for its newer partners or employees until the waiting period passes. A second practical option is to include a favorable buyout agreement in the employment contract. This will ensure that the new partner or employee has the option to purchase insurance on his or her life for a limited amount of time after joining the company.
A common source of disputes regarding cross purchase buy-sell agreements is how insurance proceeds will be distributed. Another source of disputes is how highly illiquid assets will be valued and transferred after an event triggering a sale. These disputes can be avoided if buy-sell agreements are clear about how insurance proceeds will be allocated and by agreeing in advance on how illiquid assets will be valued and how cash will be raised to finance the transfer.