What Is Cross Purchase Buy-Sell Agreement Funded By Life Insurance And How Does It Benefit Multiple Business Owners?

 

If you own a business with multiple partners or shareholders, you may want to consider a cross purchase buy-sell agreement funded by life insurance. This is a strategy that can help you protect your business and your personal interests in case of an owner’s death. It can also provide several benefits for you and your co-owners, such as liquidity, tax savings, and flexibility.

In this article, we will explain what a cross purchase buy-sell agreement is and how it works. We will also provide some benefits and drawbacks of this strategy for multiple business owners. Moreover, we will show you how to set up and fund a cross purchase buy-sell agreement with life insurance. By the end of this article, you will have a clear idea of how to use this strategy for your business succession planning.

How A Cross Purchase Buy-Sell Agreement Works

A cross purchase buy-sell agreement is a legal document that allows each owner of a business to buy the shares of another owner who dies, becomes disabled, or retires. The mechanism often relies on a life insurance policy in the event of a death to facilitate that exchange of value.

To illustrate how a cross purchase buy-sell agreement works, let’s use an example of a business with three owners: Alice, Bob, and Charlie. Each owner owns 33% of the business, which is worth $3 million. Here are the steps involved in setting up and executing a cross purchase buy-sell agreement:

• Alice, Bob, and Charlie each sign a cross purchase buy-sell agreement that states that they will buy the shares of any owner who dies or leaves the business.
• Alice, Bob, and Charlie each buy a life insurance policy on the other two owners, with a face amount equal to their share of the business value. For example, Alice buys a policy on Bob for $1 million and a policy on Charlie for $1 million. She pays the premiums and is the beneficiary of both policies.
• If Bob dies, Alice and Charlie each receive $1 million from the life insurance policy they own on Bob. They use this money to buy Bob’s shares from his estate for $1 million each. As a result, Alice and Charlie each own 50% of the business.
• If Charlie dies, Alice and Bob each receive $1 million from the life insurance policy they own on Charlie. They use this money to buy Charlie’s shares from his estate for $1 million each. As a result, Alice and Bob each own 50% of the business.
• If Alice dies, Bob and Charlie each receive $1 million from the life insurance policy they own on Alice. They use this money to buy Alice’s shares from her estate for $1 million each. As a result, Bob and Charlie each own 50% of the business.

Benefits Of A Cross Purchase Buy-Sell Agreement

A cross purchase buy-sell agreement funded by life insurance can provide several benefits for multiple business owners, such as:

• Providing liquidity and continuity for the business in case of an owner’s death: A cross purchase buy-sell agreement ensures that there is enough cash available to buy out the deceased owner’s share from their estate without disrupting the business operations or finances. It also ensures that the surviving owners can retain control of the business without having to deal with unwanted or unqualified heirs or creditors.
• Avoiding probate, estate taxes, and creditors’ claims on the business assets: A cross purchase buy-sell agreement allows the transfer of ownership to take place outside of probate court, which can save time and money. It also reduces or eliminates estate taxes on the business assets, as they are not included in the deceased owner’s taxable estate. Moreover, it protects the business assets from creditors’ claims on the deceased owner’s personal debts or liabilities.
• Giving each owner full basis credit for the purchase of the shares, reducing capital gains tax liability: A cross purchase buy-sell agreement allows each owner to increase their basis in their shares by the amount they pay for them. This means that if they sell their shares in the future, they will pay less capital gains tax on their profit.
• Allowing each owner to choose their own life insurance policy and carrier, based on their needs and preferences: A cross purchase buy-sell agreement gives each owner the freedom and flexibility to choose their own life insurance policy and carrier, based on their needs and preferences. They can select the type, amount, term, features, and cost of their policy, as well as the reputation and ratings of their carrier. They can also change or cancel their policy at any time without affecting the other owners.

Drawbacks Of A Cross Purchase Buy-Sell Agreement

A cross purchase buy-sell agreement funded by life insurance can also have some drawbacks for multiple business owners, such as:

• Increasing the complexity and cost of the arrangement as the number of owners increases, requiring more policies and premiums: A cross purchase buy-sell agreement requires each owner to buy a life insurance policy on every other owner. This means that as the number of owners increases, the number of policies and premiums also increases exponentially. For example, if there are four owners, each owner needs to buy three policies; if there are five owners, each owner needs to buy four policies; and so on. This can make the arrangement complex and costly to set up and maintain.
• Creating potential disparities and conflicts among the owners due to different ages, health statuses, and premium amounts: A cross purchase buy-sell agreement can create potential disparities and conflicts among the owners due to different ages, health statuses, and premium amounts. For example, if one owner is older or less healthy than the others, they may have to pay higher premiums or face lower coverage or higher deductibles. This may create resentment or dissatisfaction among the owners or affect their cash flow or profitability.
• Excluding the cash value of the policies from the business assets and balance sheet: A cross purchase buy-sell agreement excludes the cash value of the policies from the business assets and balance sheet, as the policies are not owned by the business but by the individual owners. This means that the business cannot use or access the cash value of the policies for any purpose, such as investing, borrowing, or paying dividends. It also means that the business cannot reflect or report the cash value of the policies as an asset or a liability on its financial statements.
• Requiring each owner to use their own after-tax funds to pay for the premiums, which are not deductible: A cross purchase buy-sell agreement requires each owner to use their own after-tax funds to pay for the premiums, which are not deductible as a business expense. This means that each owner has to pay income tax on their earnings before they can pay for their premiums. This can reduce their net income and disposable income.

How To Set Up And Fund A Cross Purchase Buy-Sell Agreement With Life Insurance

If you are interested in setting up and funding a cross purchase buy-sell agreement with life insurance for your business with multiple owners, here are some tips and steps to follow:

• Consult with a professional advisor: The first step is to consult with a professional advisor, such as an attorney, accountant, or financial planner, who can help you draft a legal document that outlines the terms and conditions of your agreement. Your advisor can also help you determine the value of your business and each owner’s share, choose a suitable life insurance policy and carrier for each owner, and review and update your agreement and policies periodically.
• Determine the value of your business and each owner’s share: The next step is to determine the value of your business and each owner’s share, using a valuation method or an independent appraiser. This will help you decide how much coverage you need for each life insurance policy and how much you will pay for each share in case of an owner’s death or departure.
• Choose a suitable life insurance policy and carrier for each owner: The third step is to choose a suitable life insurance policy and carrier for each owner, based on factors such as coverage amount, premium cost, policy features, ratings, etc. You may want to compare different types of policies (such as term life , whole life , universal life , etc.) and different carriers (such as mutual companies , stock companies , etc.) to find the best option for your situation. You may also want to consult with an independent agent or broker who can help you shop around for the best rates and offers.

• Apply for the life insurance policies and undergo medical exams and underwriting processes: The fourth step is to apply for the life insurance policies and undergo medical exams and underwriting processes. You will need to fill out an application form, provide personal and medical information, and take a physical examination that may include blood tests, urine tests, EKGs, etc. You will also need to answer questions about your business and your cross purchase buy-sell agreement. The life insurance company will then review your application and decide whether to approve or decline your policy, and at what rate and rating class.
• Review and update your agreement and policies periodically: The final step is to review and update your agreement and policies periodically to reflect any changes in your business or personal situations. For example, you may need to adjust your coverage amount or premium cost if your business value or share changes, or if you add or remove an owner. You may also need to change your policy type or carrier if you find a better option or if your policy expires or lapses. You should also review your agreement and policies with your professional advisor at least once a year to ensure that they are still valid and effective.

Conclusion

A cross purchase buy-sell agreement funded by life insurance is a strategy that can help you protect your business and your personal interests in case of an owner’s death. It can also provide several benefits for you and your co-owners, such as liquidity, tax savings, and flexibility.

However, this strategy also has some drawbacks, such as complexity, cost, disparity, and exclusion. Therefore, you need to weigh the pros and cons carefully before deciding whether this strategy is right for you.

If you are interested in setting up and funding a cross purchase buy-sell agreement with life insurance for your business with multiple owners, you need to consult with a professional advisor, determine the value of your business and each owner’s share, choose a suitable life insurance policy and carrier for each owner, apply for the policies and undergo medical exams and underwriting processes, and review and update your agreement and policies periodically.

By following these steps, you can use this strategy effectively for your business succession planning.

Don’t wait any longer. Consult with a professional advisor today and start planning for your business future with a cross purchase buy-sell agreement funded by life insurance.