Cross-purchase or stock redemption: What you don’t know can hurt your client

By Jeff Reed

Kestler Financial Group


On the surface, buy-sell planning is rather straightforward: Place insurance on all the owners so that their interest in the business can be bought out upon their death or disability. If there are more than two owners, set it up with the business as the owner and beneficiary of the policies to avoid having to purchase and manage an unwieldy number of policies.

If only it were that simple. Surviving owners may be letting a significant opportunity slip through their hands, all for the sake of perceived complexity. Shortsighted to say the least. There is much more to the story than ownership and beneficiary designations. That one seemingly basic decision has potential tax ramifications for any surviving owner of the business.

Understanding the tax implications of buy-sell agreements

When an owner dies, the probability that a business is going to be sold at some point in the future increases. One or more of the surviving owners is likely to want to walk away. When that happens, cost basis will become a major factor in their eventual payoff.

How does the type of agreement come in to play? Consider the following business:
  • Owned equally by two partners
  • The business was capitalized by a $100,000 investment from each owner
  • The business is currently worth $2 million
  • There is a fully funded buy-sell agreement in place
  • Owner A dies
One of two scenarios plays out.

Scenario 1: Stock redemption agreement

Under a stock redemption agreement, the company is the owner and beneficiary of the life insurance policies funding the agreement. At Owner A’s death, the company collects the proceeds and "redeems" the shares of stock by cutting Owner A’s estate a check for $1 million. Owner A received a step-up in basis at his death, and his heirs receive a net of $1 million. Owner B elects to sell the business, is fortunate enough to find a full-price buyer and collects a check for $2 million. Of that $2 million, $1.9 million is taxable based on his cost basis of $100,000. That is a hefty tax bill to say the least, and his net is reduced by $532,000 based on today’s capital gain rates.

Scenario 2: Cross-purchase agreement

Under a cross-purchase agreement, Owner B is the owner and beneficiary of the life insurance policy on Owner A’s life, funding the agreement and vice-versa. At Owner A’s death, Owner B collects the proceeds and purchases Owner A’s shares of stock by cutting Owner A’s estate a check for $1 million. Owner A received a step-up in basis at his death, and his heirs receive a net of $1 million. Owner B elects to sell the business, is fortunate enough to find a full-price buyer and collects a check for $2 million. Of that $2 million, $900,000 is taxable based on his cost basis of $1.1 million.

How did his cost basis go up? Owner B actually paid fair market value for the other half of the business when he executed on the buy-sell agreement. While the $252,000 of taxes due is a hefty tax bill, Owner B is $280,000 better off, simply based on the type of buy-sell agreement they elected years ago.

So what about more than two owners?
Normally, the exponential increase in the number of policies required with more than two owners sends advisors straight to the stock redemption plan. Based on the above, that can have unintended consequences in the future. So how to maintain the tax advantages of a cross-purchase structure while achieving the simplicity of a stock redemption plan?

Buy-sell plan designs using an LLC

By utilizing a manager-managed LLC to own the policies that fund the agreement, the tax treatment of the cross-purchase can be achieved while limiting the number of policies required to one per owner. While not as simple as the stock redemption plan, the potential upside for the surviving owners is more than worth the cost of a bit of legal work at plan inception.

The rest of the LLC story

As important as the taxation advantages are, they may not be the most important advantage of this approach. The issues of control and future planning flexibility are vital concerns. Consider the following:
  • Control: Upon the sale of the business, what happens to the remaining contracts? In the case of a traditional coss-purchase agreement, the other owners are under no obligation to maintain the policies, nor is there a straightforward way to transfer them from one owner to another.

  • Future flexibility: Given the challenges presented by transfers to other owners, the opportunity to re-purpose any life insurance may slip through the hands of the surviving owners. Personal protection or estate planning considerations that could be addressed with these contracts now require the purchase of new insurance contracts at attained age and current health. Transfers from the LLC to the owners of the business will likely qualify for one of the exclusions to the transfer for value rules from IRC Section 101.

  • Inclusion of policies for estate tax purposes: Personally owned contracts are usually included in the taxable estate when an owner passes away. If owned by a manager-managed LLC, policies owned by the LLC should be excluded from the taxable estate of the insured.

  • Asset protection: Policies owned in an LLC would also be afforded a level of creditor protection that is not possible with personal ownership. Clearly, for the high-net-worth business owner, the advantages of this type of plan design are significant. If most plan design decisions are based on near-term convenience, there’s a major opportunity for the thoughtful advisor to add value by exposing the risks inherent in the traditional cross-purchase design, as well as the potential taxation issues at time of sale in an stock redemption design.
For a more technical discussion of the particulars of funding a buy-sell agreement with a manager-managed LLC, contact me in the comment section below.