Cross-Purchase Buy-Sell Agreement Explained
A cross-purchase buy-sell agreement is a written contract between co-owners of a business that establishes the rights of each owner to purchase the interest of an owner who is selling or dying. The primary purpose of a cross-purchase agreement is continuity of the business despite the departure of one of the owners. This type of buy-sell agreement is used most often when there are only two owners of a business and each owner is receiving their share of the income. If a true partnership exists, however, the remaining partner(s) likely will be cashing out the departure partner’s interest upon his departure.
Under a cross-purchase plan, the owners are obligated to buy the departing owner’s interest from the co-owner spouse, heirs or personal representatives. This is in contrast to an entity redemption, which will provide that the corporation (or other entity) redeem the interest of the departing owner. The advantages of a cross-purchase plan over an entity redemption are many. For example, if the corporation redeems the owner’s interest, that owner receives dividends on a stock redemption prior to the acquisition. However, this dividend will be taxable as ordinary income. A stock redemption also will subject the remaining shareholders to double tax because the corporation will have to redeem stock, and then pay the remaining shareholders a dividend with which to pay off the stock redemption. By contrast, a sale of stock to the remaining shareholders is not subject to tax as long as it is a small business corporation (S corporation) and the shareholders will have a carryover basis in the stock and will not be taxed until the stock is sold.
At death, a cross-purchase plan has many advantages for the surviving spouse(s). Under the rules of subchapter K, a liquidation of an S corporation will result in the spouse treating the liquidation as a sale of the stock to the corporation. The spouse’s basis in the stock will step-up to fair market value, and the stock will be treated as a sale.
Of course, a cross-purchase arrangement is not without its disadvantages. For example , the buyers of the business may have a difficult time coming up with money to purchase the deceased owner’s interest.
A cross-purchase plan is especially useful when the owner has an interest in the business after the death of the spouse. For example, a husband and wife jointly own a business. Upon the death of one spouse, the survivor must buy out the deceased owner’s interest or seed the business to the children. Many times, the surviving spouse does not have the financial resources or interest in running a business alone and would rather sell the business.
The most common way of a survivor financing the purchase of the business is with the purchase of life insurance. This can be done under a cross-purchase plan whereby each spouse buys life insurance on the life of the other spouse in order to provide the funds to buy the deceased spouse’s interest or under an entity redemptive plan where the corporation buys life insurance on the lives of the owners in order to provide the funds to buy out the deceased owner’s interest.
If the husbands and wives own a 100 percent interest in a business, then they will need to purchase equal amounts of life insurance to provide funds for a full buyout of the business rather than leaving one-half of the business interest to the children of the first-to-die spouse.
Cross-purchase agreements are generally the preferred method of maximizing step-up in basis because it allows the spouse to choose whether to buy out and keep the business. If the survivor does not have the financial resources to buy out the deceased spouse’s interest, the agreement can be structured so that the children can buy the business with the proceeds of life insurance. From an income tax perspective, there are many advantages to the cross-purchase agreement. Although life insurance proceeds are included in gross estate, the spouse has a basis step-up in the business to the value at the date of death. The lender is likely going to agree to lend even if the business is not liquid because the lender is marrying into the business.
Cross-Purchase Buy-Sell Agreement Advantages
The benefits of a cross-purchase buy-sell agreement are numerous. It provides flexibility, and retains control and/or beneficial ownership in the business.
Business owners have control and flexibility over their own individual assets, and the ability to provide for their families. It is tax advantageous – insurance proceeds received on death by an individual are received income tax-free. Moreover, if policies insuring more than one life are owned by the business entity, the premiums may be obtained more cheaply than for individually owned policies because the relative risk of insurable events have decreased. Further, since the proceeds from a business owned policy are payable to a business entity, such proceeds may not be subject to claims of creditors of the deceased shareholder or purchased person. An advantage over entity redemption agreements is that a cross-purchase buy-sell agreement may be modified relatively easily to take into account changes in the business’s capital structure or membership of its employees or shareholders. Cross-purchase agreements also allow the remaining business owners the freedom to control the number, value, and disposition of the business interests they have. Business owners electing to have a cross-purchase buy-sell agreement should review the agreement to ensure that it conforms to their understanding of the effect of the buy-sell agreement (i.e., to whom do the purchase obligations under the buy-sell agreement apply, when are the purchase obligations triggered, how the purchase price is determined, what expenses are reimbursed by the purchase funds, whether a restrictive covenant is part of the transaction, and whether the seller is entitled to interest on the purchase price). In addition, the buy-sell agreement may be integrated with other estate planning devices to satisfy the owner’s business and personal needs. A buy-sell agreement permits relatively simple lifetime, inter vivos wealth and succession planning.
Differences Between Cross-Purchase and Entity-Purchase Buy-Sell Agreements
A cross-purchase agreement is a type of buy-sell agreement, but it has the same objective as an entity-purchase agreement. The primary difference between a cross-purchase agreement and an entity-purchase agreement is how each accounts for the individual who dies first. The affected parties are referred to as the buyer, or the party purchasing a deceased person’s interest.
With an entity-purchase agreement, such as a stock redemption agreement, the business entity obligates itself to buy the person’s interest, and the deceased person’s estate is relieved of its obligation to sell. The company provides the funds necessary to buy the equity from the estate, so the company, not the owners, purchases the equity of a deceased owner.
Conversely, with a cross-purchase agreement, the buyer must buy the decedent’s interest, and the decedent’s estate must sell its interest. The company does not participate in the transaction. Each party makes an agreement with the others, and the death of one of them triggers a buy-sell agreement. Each owner thus has an obligation to buy an interest in the business.
The presumption is that each owner has life insurance for the benefit of the others, who will use the death benefits to purchase the decedent’s business interest.
Essential Components of a Cross-Purchase Buy-Sell Agreement
Cross-purchase agreements typically have five components:
- Valuation Clause – As we have discussed previously, the valuation of an interest in a business can be one of the most contentious aspects of establishing a buy-sell agreement. The valuation clause in a cross-purchase agreement often calls for an appraisal or formula to be established in advance of the actual purchase so that the business value is ascertainable when a triggering event occurs.
- Funding Mechanism – Likewise we discussed the importance of having sufficient liquidity to allow a buy-sell agreement to be funded. Sufficient liquidity at the time of a triggering event is essential to the viability of a cross-purchase agreement and the best way to provide that liquidity is through insurance, either through life insurance policies or disability insurance policies. Depending on the type of insurance used, there may be tax implications or potential alterative to the use of insurance to fund a buy-sell agreement. These considerations must be addressed when drafting the cross-purchase agreement.
- Triggering Events – The triggering events that will cause a cost basis adjustment and "buy-sell" to occur must be detailed in the buy-sell agreement. Dame Young and Dame, P.C. would like to suggest the triggering events include: a) the death of a partner, b) the disability of a partner, c) resignation or retirement of a partner, or d) termination of employment due to cause. These triggering events should be agreed upon in advance and all parties to the cross-purchase agreement must receive a copy.
- Purchase Amount and Escrow – The purchase price for each remaining partner’s interest should be defined and detailed in the buy-sell agreement. Depending on the size of the purchase price, a provision should be added to the agreement defining how the purchase price is to be paid. The parties can agree to have the purchase price be placed into escrow until the sale is finalized, or demand that the payment be made immediately at the time of the triggering event.
- Amendments and Revisions – An agreement to amend a cross-purchase buy-sell agreement should be signed by each party and recorded in writing. However, an amendment to a buy-sell agreement is not always necessary. For instance, if partners were to change their minds with respect to a business valuation, they can continue to operate their business under the previously agreedupon purchase price, while in the background enforce the previously agreed to purchase price. Should one of the partners decide to leave the agreement, the remaining partners could require the partner to work out an alternative buy-out.
How to Set Up a Cross-Purchase Buy-Sell Agreement
The greatest challenge in creating a cross-purchase agreement is crafting a mutually acceptable trigger event and valuation formula. The following is a suggested breakdown of the key steps:
- Choose trigger events. Trigger events can range from the death of an owner to the retirement or disability of the owner to termination of employment for any reason. You may want to draft the agreement to allow for additional trigger events such as bankruptcy, incapacity, divorce, or termination of employment without cause. You may also want to consider whether you want to restrict the ability of the owners to transfer their interest except upon a permitted trigger event. If any of the owners do not want to be tied in to an ongoing interest in the business after a voluntary termination of employment, in addition to specifying trigger events you may want to include a provision that allows either the departing employee or the remaining owners to terminate the buy-sell agreement at any time under certain conditions.
- Determine valuation . Will the value of the cross-purchase be based on periodic appraisals, the book value as of any particular date such as the date of death, or some yet-to-be-negotiated formula? It is important for the needs of owners who are not partners that the valuation methodology avoid the complex rules for allocating appreciation or depreciation in a partnership. It is also necessary to comply with Internal Revenue Code Section 2701, which governs transfers of interests in corporations. The valuation does not need to be a qualified appraisal under Internal Revenue Code Section 170, although it is helpful, since that avoids the penalties that can apply if the IRS changes the valuation.
- Fund the buy-sell agreement. If the business will not have sufficient liquid assets readily available that can be used to fund the buy-sell, financing through the purchase of life insurance is often the best option. Under certain circumstances, if the business has sufficient liquid assets and the premiums are high, insurance funding may not be feasible. If the premium would be too expensive or if the business will not be able to buy insurance funding due to strike limitations, the purchase of annuities may be a feasible alternative.
Top Mistakes to Avoid and How
One of the most common mistakes made when drafting a cross-purchase buy-sell agreement is not adequately funding the buy-sell provisions through insurance policies. If the price for a business is not locked in, the heirs can demand full value for it upon the death of the deceased owner. If you have sufficient company assets to fund the purchase, that is generally sufficient. However, if you do not, then the only way to assure that the purchase price is "locked in" is with insurance. Otherwise, upon someone’s death, heirs can demand full value for the business, which usually is not adequate consideration to fund the buy-sell agreement.
Another mistake is not specifying a mechanism for setting the purchase price for the interest. This often comes into play when no business appraisal is performed at or around the time of the merger or acquisition. The parties usually want to buy-in at a particular time, such as the death of one of the owners or at the time the owner retirement, etc., however, they have no mechanism specified for valuing the business upon buyout. You should specify a time frame and have regular appraisals performed in order to ensure that the business is properly valued at the relevant time.
If you have a limited number of owners or shareholders, this isn’t usually a problem, but in today’s business world with several different classes of shareholders, or succession planning, where the interest has been diluted over the years by the issuance of additional shares, etc., a valuation mechanism will prevent future problems that could arise, especially when there are disgruntled shareholders involved in the buyout.
Cross-Purchase Buy-Sell Agreement: Examples and Scenarios
Case Study #1: Tri-Party Agreement Among Child’s Care Providers
Three child-care providers in a local community agreed to a cross-purchase buy-sell agreement for children between birth and 12 years of age, and decided to each purchase a life insurance policy on each of the other providers. Their collective experience has been that when one of them lost a child, they would not have the same number of kids to care for. The remaining two providers experienced increased business as a result of the loss. They recognized the lost income but also saw an opportunity to purchase the remaining provider’s business at an agreed upon value of the former practice’s blue sky.
Case Study #2: Cross-Purchase Agreement For One Business Owner
One partner of a family-owned business organized a cross-purchase buy-sell agreement. The agreement was established to pay back the deceased partner’s surviving family members for their interest in the company after the initial sixty months of monthly payments. The cross purchase agreement called for a $1 million life insurance policy on the business owner’s life, which was written by a carrier that allowed for split-dollar benefit payments in support of the monthly buyout payments.
Case Study #3: Split-Dollar Buy-Sell Agreement
A husband and wife owned a successful interior design business known for its reputation and high-end clientele. At the time the buy-sell agreement was created, the company had about $1 million in tax-free accounts; current cash holdings of about $500,000; annual sales of about $2 million; and annual earnings of $500,000. It was an up and running enterprise, known as one of the top five design companies in the U.S. at the time, but with no succession plans in place.
The couple had made major life investments in the business, and their intention was to sell the business to another interior designer, stipulating to the one condition that it would continue the business as is in its community. Further, the plan was to fund the monthly buyout payment of the owner’s wife’s share of the business with a bank financing arrangement, as well as the death benefit from the life insurance policy on her life. She was 60 years old, in relatively good health, and she and her husband argued against a cross purchase arrangement saying the cost of life insurance was too high. They decided instead to spend the money on a bank financing arrangement and a portion of the company’s cash holding, and perhaps in three to five years to use the future annual earnings to "catch up."
In the end of the year the husband suffered a fatal heart attack. Not only was his wife devastated by the loss, their children lost their father and a beloved member of the community. Her husband’s half of the business went to her "as widow" but no longer had the intended value, due to the fact that the remaining half of business could not be financed via the bank loan or by the use of company cash holding. Also, without the life insurance funding, there were no death benefit proceeds to supplement contingencies, which could have covered the down payment on the loan.
This scenario exemplifies the fact that a buy-sell agreement should be funded in such a way that it is appropriated to cover contingencies that could increase the financial obligation to the surviving family members. The decisions being made in this case were likely not due to a lack of foresight, but rather a situation that was all but impossible to predict.
Cross-Purchase Buy-Sell Agreement FAQ
There are a number of questions you might have in regards to cross-purchase buy-sell agreements, start a dialogue with your partner, or just be curious about. I try to cover some of the common inquiries I receive my clients below:
1. Do I have to sell my business under a cross-purchase buy-sell agreement?
Your cross-purchase buy-sell agreement will be binding unless you buy out your partner one of two ways:
If you do not buy your partner out by either method, then you must sell your business under the terms of the cross-purchase buy-sell agreement.
2. Can my partner and I change the terms of a cross-purchase buy-sell agreement?
Unless otherwise specified in the terms of the cross-purchase buy-sell agreement, you can change the terms by mutual consent of the signing partners. If the cross-purchase buy-sell agreement is for multiple parties, then all remaining parties must consent to any changes as well.
3. What happens if my partner goes bankrupt under a cross-purchase buy-sell agreement?
Your partner is required to sell under the terms of the cross-purchase buy-sell agreement , but it is likely that securing the full price of the sale will be difficult. In these situations, you may need to buy out your partner’s share at a discount. You should consult an experienced attorney for guidance.
4. Will a cross-purchase buy-sell agreement apply to my family members when I pass away, even if they are not owners now?
No; a cross-purchase buy-sell agreement applies only to a partner’s current full or partial ownership share at the time of passing or retirement. However, you can give the right of first refusal to your family members, allowing them to buy you out if you wish to retire. You should have a separate agreement for this and not roll it into your cross-purchase buy-sell agreement.
5. When will my family members inherit my share of a company under a cross-purchase buy-sell agreement?
You can leave the right to buy out your shares to your family members. However, this right is not mandatory concerning the inheritance of your share. The right to buy out your shares under a cross-purchase buy-sell agreement ends immediately upon death or retirement.