How It Works
A cross-purchase buy-sell agreement is implemented to protect a business, its owners, and their families in the event that one of the business owners dies. This agreement provides that the other owner or owners of a business will purchase the deceased owner’s interest in the company from his or her heirs. This agreement also makes it necessary for the deceased owner’s heirs to sell the interest to the other owner or owners of the business. A cross-purchase buy-sell agreement will specifically ensure that each of the surviving business owners individually purchase a portion of the deceased owner’s interest. This type of agreement is distinct from an entity buy-sell agreement, in which the business itself, and not the individual owners, is obligated to purchase the deceased owner’s interest in the company. A cross-purchase buy-sell agreement is very important as it helps the business to continue running smoothly after the death of a business owner. In addition, the agreement ensures that the business will remain within the control of its surviving owners, and that the heirs of the deceased owner will be fairly compensated for their inherited interest in the business.
How Is It Funded?
To provide the necessary funding for a cross-purchase buy-sell agreement, each individual owner of the business purchases a life insurance policy on the life of each of the other business owners. For example, if a partnership is valued at $1,000,000 and is owned by five equal partners, each partner must take out a life insurance policy of $50,000 on each of the other four partners so that in the event one of the partners dies, the death benefits of the combined four life insurances policies on his or her life will equal $200,000 (the value of the deceased partner’s share in the company). There is now sufficient liquidity for the remaining business owners to collectively purchase the deceased owner’s share of the business from his or her heirs.
Premiums on life insurance policies paid by individual partners are not tax deductible. However, if the business is paying the premiums as an entity (as would be the case in an entity buy-sell agreement), the premiums may be tax deductible provided that they are treated as payment to the shareholders or employees on whose part the premiums are being paid. If the premiums are treated as dividends to shareholders, the premiums are eligible for the 15% tax rate on corporate dividends that are paid to individuals, but are not tax deductible for the business or corporation.
Benefits and Potential Downsides
The benefits of a cross-purchase buy-sell agreement are clear. It will ensure that a business can continue to run smoothly after the death of a partner and that the heirs of the deceased partner will receive a fair price for their inherited interest in the business. In addition, a well-drawn agreement can fix the value of the business interest for federal estate tax purposes.
A cross-purchase buy-sell agreement can become complicated when there are many owners of a business, as the number of life insurance policies that need to be purchased increases exponentially. For example, if there are 7 partners in a business, there would need to be a total of 42 life insurance policies purchased. In addition, there may be large age disparities between the partners, which would require younger partners to pay higher premiums for policies on the older partners. This can become costly and cumbersome.
To conclude, having some sort of buy-sell agreement in place in the event that a business owner passes away is extremely important to protect your business, its owners, and the inheritance of their family members. Before moving forward it is important to obtain proper legal advice to evaluate and review all of the consequences of these agreements.