O—Cross Purchase Agreement During Lifetime and Upon Death

The cross purchase agreement is one means of providing for the complete disposition of a business interest. Under this arrangement the owners agree, among themselves, to buy and sell their respective interests.

DURING LIFETIME. To illustrate how this works, assume that we have a corporation equally owned by two individuals, A and B. They enter into an agreement providing for the purchase and sale of their respective interests. Typically, this agreement is binding and obligates both parties, or their representatives, to either buy or sell upon the death, disability, or retirement of either A or B.

Rather than trying to accumulate or borrow sufficient funds to buy B’s interest, A obtains a life insurance contract insuring B. A applies for this coverage, pays the premiums, and is both owner and beneficiary of the contract. Likewise, B applies for a life insurance contract insuring A, pays the premiums, and is both owner and beneficiary. By this means, A and B can use life insurance to fully fund their mutual obligations to each other.

UPON DEATH. Assuming that A dies first, his stock interest would then pass to his family or estate. At the same time, the insurance company pays a death benefit to B, as beneficiary of the contract insuring A’s life. B receives these funds free of all income taxes, since they are received as the death benefit of a life insurance contract.

Pursuant to the agreement, A’s family, or estate, transfers A’s entire stock interest in the corporation to B, in return for which B pays the cash received from the insurance company.

The fully funded agreement will assure that A’s surviving family receives a fair price for his interest in the business. But such an agreement can also serve another very important function. If the estate had been subject to estate taxes, it is possible that extensive negotiations and even litigation could result if the estate tax value of the business had been left to chance. These problems of delay and litigation can be avoided by having a cross purchase agreement which helps establish, or “peg,” the value of the stock.

Given the importance of income and capital gains tax planning, a cross-purchase arrangement increases the remaining owners’ cost-basis by the purchase price. This is the primary advantage over an entity buy-sell arrangement.

Although term insurance alone can provide funding for a buy-out at death, the reality is that disability, retirement, and disagreement among owners is a far more common reason for an owner to leave a business. It is important that planning and funding for those eventualities also be considered.