Plan Ahead for Your Business Partners and Their Families

A cross-purchase plan funded by life insurance works like this: each co-owner buys a policy on the lives of the other owners. When an owner dies, the policy pays cash, and the surviving owner uses that cash to buy the deceased owner’s share. The steps are simple, but the details decide whether the plan works. This page walks through them in plain words, including the tax points a CPA reviews.

What a cross-purchase buy-sell plan is, in plain words

A cross-purchase buy-sell plan is an agreement where the co-owners of a business buy a departing owner’s share directly. The company itself does not buy it.

A buy-sell agreement is a contract among co-owners. It sets what happens to an owner’s share when that owner dies, becomes disabled, retires, or leaves. It says who must buy, who must sell, and at what price or by what formula.

The “cross-purchase” label describes who buys. In this structure, the individual owners are the buyers. That choice affects ownership, taxes, and paperwork, and we cover those points below.

Co-owners often fund the purchase with life insurance. The policy pays cash when an owner dies, which is when the buyout usually happens. Without that cash, the survivor may need to borrow, pay over time, or sell other assets to complete the deal.

For the full overview of how buy-sell coverage fits into a business plan, read our buy-sell agreement life insurance guide.

Who owns the policy, who pays the premium, and who is the beneficiary?

In a cross-purchase plan, each owner owns a policy on every other owner. The owner who holds the policy is usually the one who pays its premium and is named as beneficiary.

With two owners, you need two policies. Owner A owns a policy on Owner B, and Owner B owns a policy on Owner A. That setup lets the survivor receive the cash when the other owner dies.

Who pays the premium is a business decision. Some owners split the cost by ownership share. Others pay for their own policies. The agreement should say which method applies, so no one has to guess later.

The agreement should also say what happens if an owner stops paying. Florida law requires every insurance contract to allow a grace period of not less than 30 days for paying any premium after the first. During that period, the policy stays in force. The insurer may charge interest of not more than 8 percent per year for those grace days, according to Fla. Stat. § 627.453.

Fla. Stat. 627.404 provides that a contract of insurance upon a person (other than a policy of prepaid funeral contract, group life insurance, or group or blanket accident, health, or disability insurance) may not be carried out unless, on or before the time of entering into the contract, the person insured, having legal capacity to contract, applies for or consents in writing to the contract and its terms. The exception is that any person having an insurable interest in the life of a minor younger than 15 years of age, or any person upon whom a minor younger than 15 years of age is dependent for support and maintenance, may obtain a policy of insurance on the minor. The same statute, Fla. Stat. 627.404, states that the signature of the proposed insured, having capacity to contract, on the application for insurance shall constitute his or her written consent for purposes of that section. Every owner should sign the paperwork for the policy on his or her own life. The state statute on insurable interest in Fla. Stat. § 627.404 covers these rules.

What happens step by step when an owner dies?

When an owner dies, the policy owner files a claim, and the insurer pays the death benefit to the named beneficiary. Under the agreement, the surviving owner then buys the deceased owner’s interest from the estate.

Here is the sequence in plain steps:

1. The insured co-owner dies.
2. The policy owner files a claim with the insurer.
3. The insurer pays the death benefit to the beneficiary named on the policy.
4. The surviving owner buys the deceased owner’s interest, at the price or formula the agreement sets.
5. The estate receives the purchase price, and the survivor takes full ownership of the interest.

The company is not a party to the purchase in a cross-purchase plan. That is the key difference from an entity-owned arrangement. The survivor, not the business, is the buyer.

How this plays out depends on how the agreement is written and on the facts of each business.

How are the proceeds used under the agreement?

The agreement sets the buyout price or formula, and the insurance proceeds provide the cash to pay it. The policy does not set the price. The agreement does.

Some agreements use a fixed price that owners review each year. Others use a formula based on earnings or book value. Many call for an appraisal at the time of death.

Tax valuation uses a different test. Under federal regulations, the fair market value of a business interest is the net amount a willing buyer would pay a willing seller. The test looks at all relevant factors, including the business’s assets (with goodwill) and its demonstrated earning capacity, as described in 26 C.F.R. § 20.2031-3. The agreed price and the tax value can differ, so a CPA checks both.

The agreement should also say what happens to any difference between the death benefit and the agreed price. If the benefit is larger, the agreement should state where the extra goes. If it is smaller, the agreement should explain how the gap is closed, such as through a payment plan. Owners often skip these terms, and the gap shows up later.

The death benefit is usually paid in one lump sum. The survivor can use that cash to complete the buyout.

Which tax points does a CPA review in a cross-purchase plan?

Life insurance death benefits are generally not taxable income to the beneficiary. The IRS notes that interest paid on proceeds held by the insurer is taxable, according to its life insurance proceeds FAQ.

Several rules can change the picture. The main rule is in 26 U.S.C. § 101. That section also contains a transfer-for-value rule. Under IRC § 101(a)(2), when a life insurance contract or any interest in it is transferred for a valuable consideration, the death benefit excluded from gross income is capped, so part of the income-tax exclusion can be lost. Under IRC § 101(a)(2), the cap does not apply in several listed situations, including a transfer to the insured, a transfer to a partner of the insured, a transfer to a partnership in which the insured is a partner, or a transfer to a corporation in which the insured is a shareholder or officer. The statute contains other exceptions as well, including one for carryover basis. Under IRC § 101(a)(3), however, these exceptions do not apply to a reportable policy sale. Section 101 also defines a “reportable policy sale” as an acquisition of an interest in a life insurance contract where the acquirer has no substantial family, business, or financial relationship with the insured apart from that interest. Ownership changes should be reviewed before they happen.

Estate tax rules add another layer. Under 26 U.S.C. § 2042, insurance can count toward a decedent’s gross estate when it is receivable by the executor, or when the decedent held ownership rights in the policy at death. A cross-purchase plan spreads policies across owners, so those ownership rights need careful review.

Under IRC § 2035, certain transfers made within three years of death may still bring property back into the gross estate.

Our CPA review addresses the tax and cash flow questions. Insurance recommendations come from a licensed insurance agent, separately from the accounting practice.

How does a cross-purchase plan work with three or more owners?

With more than two owners, each owner needs a policy on each of the other owners. The number of policies grows faster than the number of owners.

With two owners, the plan needs two policies. With three owners, it needs six policies, because each of the three owners holds a policy on each of the other two. With four owners, it needs twelve.

That count affects administration. Each policy has its own premium dates, beneficiary records, and insurer contact. More policies can also mean more paperwork at each ownership change, such as when an owner retires or a new owner joins.

An entity-owned plan works differently. The business owns one policy on each owner, so the count is lower. The entity route has its own tax rules. Controlling stockholder means more than 50 percent of total combined voting power. This page does not recommend one structure over the other.

What should you confirm before relying on the plan, and how do you start a coverage review?

Before relying on the plan, confirm the agreement terms and each policy’s details. Gaps in either one cause problems at the worst time.

For the agreement, check:

• The valuation method and the trigger events, such as death, disability, retirement, or departure.
• Who pays each premium, and what happens if an owner stops paying.
• How the agreement is updated when ownership changes.

For each policy, check:

• The insurer, the policy form, the owner, and the beneficiary.
• Whether the policy is whole life insurance or term life insurance.
• That each insured owner signed the required written consent.

If you’re reviewing this plan after a co-owner’s death or a health change, our team can help you start. Your first step with NR CPAs & Business Advisors is a coverage review, a meeting to go over the agreement and the policies involved. You can contact us here to begin.

Insurance is offered by Nischay Rawal, a licensed insurance agent, separately from the accounting practice of NR CPAs & Business Advisors.