I—Trusteed Cross Purchase Agreement

The trusteed cross purchase agreement is one means of providing for the complete disposition of a business interest. Trusteed cross purchase agreements are also known as “custodian” or “escrowed” agreements. The provisions for an escrow agent can be part of the cross purchase agreement, or provided for in a separate agreement. The trusteed cross purchase agreement can be used with either a corporation or a partnership. With a sole proprietorship, a similar escrowed arrangement could be established between the sole proprietor and a key employee. However, since the key employee has no ownership interest, there are no reciprocal obligations to buy and sell. The sole proprietor would merely be obligated to sell and the key employee obligated to buy.

Under this arrangement the owners use a third party to carry out their cross purchase agreement. Although sometimes referred to as a “trustee,” this individual is not acting as a trustee in a formal trust sense. Rather, the trusteed cross purchase agreement more closely resembles an escrow arrangement, under which an escrow agent acts as agent for the owners in carrying out their mutual obligations to each other.

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

To implement the agreement the stockholders transfer their stock certificates to the escrow agent, and further have the escrow agent purchase life insurance on each stockholder. In a family-owned business the attribution rules under Code section 101(j) may treat these policies as “employer-owned.” This would subject the death benefits to income taxation. To assure the proceeds are received free of income taxes, appropriate notice and consents should be obtained.  

The escrow agent is both owner and beneficiary of these contracts and pays any required premiums. Since the escrow agent pays the premiums on behalf of the owners he or she obtains the funds from the owners (e.g., B, C and D benefit from and therefore must pay the premiums for the policy insuring A). Although the premiums are not tax-deductible, split-dollar plans could be used to assist the owners in paying for the life insurance.

By this means the stockholders can use life insurance to fully fund their agreement, while having the assurance that their mutual obligations to each other will be carried out by the escrow agent. Use of an escrow agent can substantially reduce the number of policies required to fund the agreement.

UPON DEATH. Assuming that A dies first, the insurance company pays a death benefit to the escrow agent, as beneficiary of the contract insuring A’s life. The escrow agent 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, the escrow agent then transfers A’s entire stock interest in the corporation to the surviving stockholders, in return for which the escrow agent pays the cash received from the insurance company to A’s family.

After the first death there is a potential transfer for value problem upon the transfer of the deceased stockholder’s ownership interests in the remaining policies insuring the surviving stockholders. Sometimes a similar partnership structure is used to avoid this concern.

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 trusteed cross purchase agreement which helps establish, or “peg,” the value of the stock. To help “peg” the value, the parties must be required to sell during lifetime for the same price as provided for a sale at death. In addition, the agreement must specifically bind A’s estate or family and further comply with the Chapter 14 requirements.