What Is a Cross Purchase Agreement?
A cross purchase agreement is a legally binding contract among co-owners of a business that outlines the terms for buying out a departing owner's interest. This type of agreement is a critical component of business succession planning for closely held companies. Rather than the business itself repurchasing the shares, each remaining business owner individually agrees to purchase a proportionate share of the departing owner's interest. A cross purchase agreement is typically triggered by events such as an owner's death, disability, retirement, or a desire to sell their interest. It ensures a smooth transition of ownership, provides liquidity to the departing owner or their estate, and maintains control within the existing ownership group.
History and Origin
The concept of buy-sell agreements, of which the cross purchase agreement is a primary form, has evolved alongside the increasing complexity of business ownership and the need for continuity. As partnerships and closely held corporations became more common, owners sought mechanisms to control who could become a co-owner and to provide an orderly exit strategy without disrupting business operations. Early forms of such agreements emerged to address issues of control and liquidity in private businesses, helping to prevent shares from falling into the hands of unwanted outsiders. These agreements became particularly formalized with the rise of modern corporate law and the recognition of their role in stable partnership structures.5
Key Takeaways
- A cross purchase agreement is a contract where individual co-owners agree to buy a departing owner's interest.
- It is a core instrument for business continuity and succession planning in closely held businesses.
- Funding for cross purchase agreements often comes from life insurance policies that owners hold on each other.
- Upon an owner's exit, the purchasing owners receive a favorable step-up in cost basis for the acquired shares.
- Cross purchase agreements can become administratively complex with a large number of owners due to the multiple insurance policies required.
Interpreting the Cross Purchase Agreement
A cross purchase agreement is interpreted as a direct transaction between individual owners, distinct from transactions involving the business entity itself. This structure has significant implications, particularly concerning taxation and ownership basis. When an owner's interest is purchased under a cross purchase agreement, the acquiring owners directly assume the ownership of those shares. This direct transfer allows the purchasing owners to establish a new, stepped-up cost basis in the acquired shares, equal to the purchase price. This adjusted basis can be advantageous for future sales of their ownership interests, potentially reducing future capital gain taxes. The agreement also establishes clear rules for the valuation of the business interest, ensuring fairness and predictability for all parties involved.
Hypothetical Example
Consider "Tech Solutions Inc.," a small business owned by three individuals: Alice, Bob, and Carol, each holding an equal one-third share. They have a cross purchase agreement in place, funded by life insurance policies. Each owner owns and is the beneficiary of a policy on the lives of the other two owners.
If Alice unexpectedly passes away, Bob and Carol, as the surviving owners, would receive the death benefits from the policies they held on Alice's life. According to their cross purchase agreement, they would then use these proceeds to individually purchase Alice's one-third share from her estate. If Alice's share was valued at $300,000, Bob and Carol would each contribute $150,000 to purchase her shares. Following the transaction, Bob and Carol would each own 50% of Tech Solutions Inc., and their cost basis in their expanded ownership would be stepped up by the amount they paid for Alice's shares. This process ensures Alice's estate receives fair value for her interest, and the business continues seamlessly under Bob and Carol's control without the need for an external buyer.
Practical Applications
Cross purchase agreements are widely used in small business and closely held company environments to manage ownership transitions. They are particularly beneficial for ensuring business continuity and providing liquidity to a departing owner's estate or to the owner themselves upon retirement or disability. A key advantage of the cross purchase structure lies in its tax implications for the surviving owners. When structured properly, the life insurance proceeds used to fund a cross purchase are typically received income tax-free by the individual owners.4 Furthermore, the acquiring owners receive a stepped-up cost basis in the purchased shares, which can significantly reduce future capital gain taxes if they later sell their interests. This is a notable distinction, especially in light of recent judicial rulings that have impacted the valuation of businesses under alternative buy-sell structures. For instance, the Supreme Court case Connelly v. U.S. highlighted that life insurance proceeds paid to a corporation under an entity redemption agreement could increase the value of the deceased shareholder's estate for estate tax purposes.3 Conversely, a cross purchase arrangement avoids this specific valuation issue because the life insurance is owned by the individuals, not the entity, and therefore is not included in the corporate valuation.
Limitations and Criticisms
Despite their advantages, cross purchase agreements do come with limitations, particularly concerning administrative complexity as the number of shareholders increases. For example, if there are (n) owners, a cross purchase agreement typically requires (n \times (n-1)) individual life insurance policies. This rapidly escalates: three owners require six policies, four owners require twelve, and so on. This proliferation of policies can make administration cumbersome, requiring careful due diligence to ensure all premiums are paid and policies are kept current.2
Another potential drawback arises when there are significant age or health differences among owners, leading to disparate premium costs, which can create friction. While solutions like bonus plans (where the company bonuses owners funds to pay premiums) can mitigate this, they add another layer of complexity. Additionally, while the direct receipt of death benefits by individuals under a cross purchase agreement is generally income tax-free, careful planning is necessary to avoid "transfer-for-value" issues if policies are transferred between owners for consideration in certain scenarios.1
Cross Purchase Agreement vs. Entity Purchase Agreement
The cross purchase agreement and the entity purchase agreement are two primary structures for a buy-sell agreement, designed to facilitate the orderly transfer of business ownership. The fundamental difference lies in who purchases the departing owner's interest and who owns the funding mechanism, typically life insurance.
| Feature | Cross Purchase Agreement | Entity Purchase Agreement (Stock Redemption) |
|---|---|---|
| Purchaser | Surviving individual owners | The business entity (corporation, LLC, partnership) |
| Policy Ownership | Each owner holds policies on the lives of other owners | The business entity holds policies on the lives of each owner |
| Number of Policies | Increases significantly with more owners ((n \times (n-1))) | Simpler: one policy per owner ((n)) |
| Basis Step-Up | Surviving owners receive a stepped-up cost basis on purchased shares | No step-up in basis for remaining owners; business's basis is adjusted |
| Estate Tax | Generally avoids inclusion of insurance proceeds in business valuation for estate tax | Insurance proceeds may increase business value for estate tax purposes, potentially increasing estate tax liability |
| Administration | More complex with many owners | Generally simpler with many owners |
Confusion often arises because both types of agreements serve the same ultimate purpose: to ensure business continuity and provide a market for a departing owner's interest. However, their distinct structural and tax implications make the choice between them crucial, dependent on the number of owners, their financial situations, and specific succession planning goals. While a cross purchase agreement offers advantages related to basis step-up and estate tax avoidance, an entity purchase agreement offers administrative simplicity, especially for businesses with numerous owners.
FAQs
What is the main purpose of a cross purchase agreement?
The main purpose is to ensure a smooth and orderly transfer of ownership interest in a closely held business when an owner departs due to death, disability, retirement, or other agreed-upon events. It provides a pre-arranged market for the owner's shares and a funding mechanism for the purchase, preventing business disruption.
How is a cross purchase agreement typically funded?
Cross purchase agreements are commonly funded with life insurance policies. Each business owner purchases a policy on the life of every other owner. Upon a triggering event like death, the surviving owners receive the policy proceeds and use them to buy the deceased owner's shares directly from their estate.
What are the tax benefits of a cross purchase agreement?
One significant tax benefit is that the surviving owners receive a "step-up" in their cost basis for the shares they acquire. This means their new basis is the purchase price, which can reduce their future capital gain tax liability if they later sell their augmented ownership interest. Additionally, the life insurance proceeds used for funding are generally received income tax-free.
Can a cross purchase agreement be used for businesses with many owners?
While effective, a cross purchase agreement becomes administratively complex with many owners due to the large number of individual life insurance policies required. For businesses with numerous owners, an entity purchase agreement might be simpler to administer, although it has different tax implications.
What happens if an owner doesn't pay their life insurance premiums in a cross purchase agreement?
If an owner fails to pay premiums on the policies they own, those policies could lapse, leaving the agreement unfunded. This highlights the need for a fiduciary or a trust to oversee the policies or a clear mechanism within the agreement to address non-payment, ensuring the viability of the buy-sell agreement.