A cross-purchase agreement is a buy-sell arrangement in which the remaining individual owners purchase a departing owner’s shares directly, rather than having the business entity itself make the purchase. In this structure, each owner typically maintains life insurance policies on the other owners, using the death benefits to fund the purchase of a deceased partner’s interest. This approach offers several significant advantages for business succession planning.
Cross-purchase agreements provide surviving owners with a step-up in tax basis equal to the purchase price paid for the acquired shares, which can substantially reduce capital gains taxes upon a future sale of the business. The insurance death benefits are received income-tax-free, providing immediate liquidity without creating taxable income. Perhaps most importantly in light of recent legal developments, cross-purchase agreements avoid the estate tax complications that can arise with alternative structures.
The Supreme Court’s decision in Connelly v. United States has made cross-purchase agreements particularly advantageous. In Connelly, the Court ruled that when a company uses corporate-owned life insurance to fund a redemption agreement, those insurance proceeds must be included in the company’s value for estate tax purposes, resulting in higher tax liability than anticipated. With a cross-purchase agreement, the insurance proceeds go directly to the surviving owners and are never included in the corporation’s value, completely avoiding this estate tax issue.
Funding Cross-Purchase Agreements
Successfully implementing a cross-purchase agreement requires adequate funding to complete the purchase of a departing owner’s interest. Among the available funding mechanisms, life insurance, installment payments, cash reserves, sinking funds, and bank loans, life insurance is frequently the preferred option due to its cost efficiency and favorable tax treatment. In a cross-purchase structure, each owner purchases and maintains life insurance policies on the other owners, with death benefits paid directly to the surviving owners who then use those proceeds to purchase the deceased partner’s shares. This approach provides immediate liquidity at the time of need and, importantly, the death benefits are typically received income-tax-free. As demonstrated in Connelly, this structure offers a significant advantage over redemption agreements because the insurance proceeds are not included in the business’s valuation for estate tax purposes, thereby avoiding the increased tax liability that befell the taxpayers in that case.
However, cross-purchase arrangements introduce complexities that require careful consideration. As the number of business owners increases, the administrative burden grows substantially due to the proliferation of required policies. Additionally, disparities in premium costs inevitably arise from differences in owners’ ages and health conditions, which can create perceived inequities. Each owner must also qualify for life insurance coverage, introducing concerns about insurability and affordability that may make this funding method impractical in some situations. For these reasons, many business owners opt for a hybrid approach, using life insurance to fund buyouts triggered by death while relying on installment payments or other methods for retirement or voluntary departure scenarios.
Practical Considerations
While cross-purchase agreements offer substantial tax and succession planning benefits, they require careful implementation and ongoing attention. The administrative complexity increases significantly with the number of owners involved. A business with three owners requires six separate insurance policies, while four owners require twelve policies. Each policy must be properly owned, maintained, and coordinated with the other owners, creating a web of obligations that demands diligent oversight.
Premium cost disparities present another practical challenge. Owners of different ages or with varying health profiles will face significantly different insurance costs, which can create tension and perceived inequities among partners. Some owners may struggle to afford premiums on older or less healthy partners, while those same partners benefit from lower premiums on younger, healthier colleagues. The agreement must address how these disparities will be handled and whether any cost-sharing mechanisms should be implemented.
Insurability itself can pose obstacles. Each owner must qualify for life insurance coverage, and those with pre-existing health conditions may find coverage prohibitively expensive or entirely unavailable. In such cases, alternative or supplementary funding mechanisms may be necessary, or the agreement may need to provide for different treatment of insurable versus uninsurable owners.
Beyond the initial setup, cross-purchase agreements require regular maintenance to remain effective. The business valuation method specified in the agreement should be reviewed and updated annually to ensure it accurately reflects the company’s current worth. Insurance coverage must be reassessed as the business grows to confirm that death benefits remain adequate to purchase a departing owner’s interest. Changes in ownership structure, whether through the addition of new partners or changes in ownership percentages, necessitate corresponding adjustments to the agreement and insurance arrangements. Finally, developments in tax law, such as the Connelly decision itself, may require amendments to ensure the agreement continues to achieve its intended tax and succession planning objectives.
Conclusion
A well-structured buy-sell agreement is essential for small business exit planning. The Connelly decision has highlighted important tax advantages of cross-purchase agreements over redemption agreements for business owners with significant estates.
If you are considering your exit strategy or need to review your existing buy-sell agreement, please contact the attorneys at D’Ambrosio LLP. Our team can help you structure an agreement that protects your business and minimizes tax exposure.
