Plan the Buyout Before the Need Arises

If you share ownership of a business with others, a cross-purchase buy-sell agreement is a written deal you make with your fellow owners. Each owner agrees to buy a departing owner’s share. Each owner also buys life insurance on the others, so the money is there when a loss happens.

Choosing between a cross-purchase structure and an entity-purchase form depends on who owns and pays each policy, where the structure falls short, and how the two differ. It is written for Florida owners and families who have just learned about one.

What a cross-purchase buy-sell agreement means

A cross-purchase buy-sell agreement is a written contract among business owners. It sets what happens to an owner’s share if that owner dies, becomes disabled, retires, or leaves.

The defining feature is who does the buying. In the cross-purchase form, the owners buy each other’s interests directly. The company does not buy them.

Owners use this form to keep control with the people who run the business. The agreement answers the ownership question before a loss, not after it.

Other names are sometimes used for a buy-sell agreement. The generic term is “buy-sell agreement,” and life insurance is simply the tool that pays for the buyout. It is not an investment or a savings plan.

Under Fla. Stat. § 607.0732, a shareholder agreement made under that section must be in writing. If owners want their shareholder agreement to fall under this section, it must either be set forth or referenced in the articles of incorporation or bylaws and approved by all shareholders at the time of the agreement, or be signed by all shareholders at the time and made known to the corporation; the section does not invalidate other shareholder agreements that are otherwise valid. Fla. Stat. § 607.0732

How the cross-purchase structure works step by step

Each owner agrees to buy a share of every other owner’s interest if that owner leaves or dies. Then each owner buys and owns a life insurance policy on each of the other owners.

Take three owners: Ana, Ben, and Carl. Ana owns policies on Ben and Carl. Ben owns policies on Ana and Carl. Carl owns policies on Ana and Ben. That is six policies in total.

Suppose Ben dies and the agreed price for his share is $300,000. This is a hypothetical example. Ana and Carl each use the proceeds from the policy they own on Ben. Together, that money pays the price, as the agreement says.

Each owner pays the premiums on the policies he or she owns. Premiums are due on a schedule, whether or not the business is doing well.

Florida law limits who can buy insurance on another person’s life. No one may do it unless the benefits go to that person, or to someone with an insurable interest when the contract is made. Under Florida law, the insured, if having legal capacity to contract, must also apply for or consent in writing to the contract and its terms on or before the time of entering into it, unless the policy is a prepaid funeral contract, group life insurance, or group or blanket accident, health, or disability insurance. An exception lets a person with an insurable interest in a minor younger than 15, or a person the minor depends on for support, obtain a policy on the minor without that consent. Fla. Stat. § 627.404

Who owns, pays, and receives the proceeds

Every policy has three roles. The policy owner pays the premiums and controls the policy. The insured is the person whose life is covered. The beneficiary receives the death benefit.

In a cross-purchase plan, the surviving owner who holds the policy is the beneficiary. The proceeds pass to that owner, who uses them to complete the buyout.

Each policy is a separate contract with the insurer named on it. The agreement and the policies should be reviewed together, so the terms match.

Income tax and estate tax follow different rules. Under 26 U.S.C. § 101, amounts paid because of the insured’s death are generally excluded from gross income. That rule has listed exceptions, so tax results depend on the facts.

Estate inclusion is a separate question. In this form, the insured usually does not own the policy, but IRC § 2042 still includes in the estate any insurance proceeds receivable by the executor. It also includes proceeds receivable by other beneficiaries if the insured held any incidents of ownership at death, exercisable alone or with any other person.

Common drawbacks of the cross-purchase form

The biggest drawback is growth. Every new owner adds policies. Two owners need two policies. Three owners need six. Four owners need twelve.

Premiums can be uneven. Owners of different ages or health pay different amounts on the same structure. Whether a policy issues depends on each insured’s health and the insurer’s underwriting. One owner may be declined or charged more.

Moving an existing policy from one owner to another can change tax results. Section 101 has exceptions that apply to transfers, so get the facts reviewed before any change.

Surviving owners also need cash. The timing of premium payments and the cash needed for a buyout should be planned before a loss.

Cross-purchase compared with an entity-purchase arrangement

An entity-purchase, or redemption, arrangement works differently. The company owns and pays for the policies on each owner. The company buys the departing owner’s interest.

• Number of policies: Cross-purchase needs one policy per owner for each other owner. Entity-purchase needs one policy per owner.
• Who owns the policies: In cross-purchase, each owner. In entity-purchase, the company.
• Who buys the interest: In cross-purchase, the surviving owners. In entity-purchase, the company.
• Where proceeds go: In cross-purchase, to the surviving owners. In entity-purchase, to the company.

Estate rules can differ for a controlling stockholder. Where a decedent is the sole or controlling stockholder of a corporation, the corporation’s incidents of ownership in a policy on the decedent’s life may be attributed to the decedent through that stock ownership, under the rules set out in subparagraph (6) of 26 C.F.R. § 20.2042-1, but the corporation’s incidents of ownership will not be attributed to the decedent through that stock ownership to the extent the proceeds of the policy are payable to the corporation. 26 C.F.R. § 20.2042-1

For a two-owner business, read the two-owner companies guide. The funding guide explains how the policies pay the buyout. Neither form suits every business.

If you are looking into this for a co-owner or family member

Start with three checks: that each policy exists, who owns and pays each one, and whether the written agreement matches how the policies are funded. If a co-owner has died, become seriously ill, or is leaving, these checks come first.

A coverage review can help you compare the agreement with the policies in place. Commission-based insurance compensation is also disclosed in writing before any engagement.

If a co-owner has just died or is leaving, you do not have to sort out the policies alone. Contact NR CPAs & Business Advisors to request a coverage review. Insurance is offered by Nischay Rawal, a licensed insurance agent in Florida, separately from the accounting practice.