All About Cross Purchase Agreements: A Primer for Business Owners

What’re Cross Purchase Agreements?

A cross purchase agreement is a legally binding contract between partners or co-owners of a business and the most fundamental purpose is to ensure ultimate control over the future of that business, whether by a co-owner or a chosen third-party, at some point in the future. It is typically used in business succession planning but can also be used for tax and/or other purposes. They are generally purchased at the time a business is purchased or formed (or at some future point) and spell out fairly simply how an ownership interest in a business will be transferred from one person to another or an entity upon the death or disability of a partner or co-owner.
They are different than buy-sell agreements (also known as buy and sell agreements). A buy-sell agreement is a form of cross purchase agreement which is the same as a cross purchase agreement except that it typically includes restrictions on the sale of the business to third-parties, or non-participants, and may specify what purchase price must be paid should the business be sold to outside parties . For example, a closely held business with three owners may decide that if one of the owners passes away (or becomes disabled), his or her interest in the business will pass to the remaining owners who will have the first right to purchase it, then allow family members of the deceased / disabled owner to have the option to purchase it if the remaining owners don’t exercise it, and then finally, if neither the remaining owners nor the relatives of the deceased / disabled owner exercise their options, the business will be sold to a third party on a certain schedule with a purchase price agreed upon.
It is important that any well drafted cross purchase agreement or buy-sell agreement is carefully reviewed by knowledgeable counsel to determine whether or not this is an appropriate option for you.

Cross Purchase Agreement Essentials

The overall structure of a cross purchase agreement is relatively straightforward: it generally contains the fundamental elements of a typical contract—an offer, acceptance, consideration and mutuality. However, there are certain key features for which this type of agreement is known. Here’s a brief overview of those common features:
Parties: A cross purchase agreement is entered into by the owners of a business entity. While it can be entered into by just one owner, in order for it to be effective it must be a definitive agreement that outlines the terms for all the current owners to make the required purchase.
Insured amounts: One of the key features of a cross purchase agreement is that the price for the buyout of a deceased or departing owner is set at the insured amounts designated in their respective insurance policies. The agreement should make it clear that the owner who leaves the company does not need to collect the value of the buyout from other owners, but will gain this value by cashing out the life insurance policies they hold on each other.
Funding: The policy underlying a cross purchase agreement is owned by either the individual owners or by the company as a whole. In broad terms, the funds for the buyout of a deceased or departing owner can be generated by the sale of the policy itself back to the insurance company (assuming it makes it through underwriting), or through dividends or the cash surrender value of the policy.
Default provisions: A cross purchase agreement often has default provisions that require departing owners to sell to the remaining members of the business. These provisions are important, because if a business chooses to hire an outside person in one of its key roles, the company could have certain liabilities that default provisions would not cover.
Termination: A cross purchase agreement terminates upon the unwinding of the business.

Cross Purchase Agreement Benefits

One of the most significant advantages of cross purchase agreements is that they can be structured in a manner that provides important tax benefits both to the company and the individuals involved. The business will benefit in many cases from the immediate tax deduction for premiums, while shareholders can benefit from long-term deferral of capital gains tax or even total avoidance of capital gains tax upon sale of life insurance policies.
Aside from the tax benefits, a cross purchase agreement helps ensure business continuity and stability by preventing the departure of a shareholder and the entry of a non-qualified individual into the business. In many ways, life insurance is the backbone of a cross purchase agreement as it provides an immediate source of cash upon a shareholder’s death. Many business owners simply prefer to know that their business is protected from a departure whether by death or voluntary termination.
Finally, cross purchase agreements offer individual shareholders a layer of protection in that they help ensure that under nearly all circumstances shares will be owned by other qualified individuals and not outsiders.

Creating a Cross Purchase Agreement

An essential step in creating a cross purchase agreement is identifying who the potential purchases of the business interest are. This may not always be clear in that the purchasers may be the remaining owners or shareholders, or relatives of the owner (if the arrangement is between relatives). It is also important to clearly identify what separates the trigger event from the ensuing rights and obligations. In other words, what is a trigger event, when does it happen and how does it affect the parties? For example, in the case of a divorce, rare is the situation where the share interest is actually awarded to the spouse as opposed to being purchased out by the co-owners. A divorce might not result in the share portion being awarded to the divorcee, yet the divorce condition may well trigger the rights and obligations of all portions of the cross purchase agreement. Depending on the type of arrangement, it is important to consider how to deal with a contingent event. While the most common examples of such events are those involving a death, disability or termination of employment, there are other examples such as divorce or relocation. Dealing with the question of whether the company should have a buy-out option for the shares is also a relevant consideration as part of drafting a cross purchase agreement. The valuation of the shares is also a significant point of consideration in drafting a cross purchase agreement. There are a variety of approaches to valuing a business, however the most common approaches are referred to as earnings and asset-based approaches. The randomly generated formula is almost always unsuitable to establish the value of the business interest for someone who may be some day buying or selling a business interest. More specific guidance on business valuation is available in other posts on this blog.

Cross Purchase Agreements: Issues and Considerations

Common challenges in the implementation of a cross purchase agreement are valuation disputes and how to fund the purchase. An independent valuation of the business is the recommended solution to the valuation dispute. Having the business or a company controlled by the business hold the insurance policy on the life of each shareholder (the cross purchase agreement will require shareholders to obtain and keep such a life insurance policy) , may be the most effective solution for funding the purchase after death of the owner.

Cross Purchase vs. Entity Purchase Agreements

In contrast with a cross purchase agreement, an entity purchase agreement will provide that it is the business entity that will buy the interest of the deceased owner or the owner who has left the business for whatever reason. The business entity pays the money to the estate of the deceased owner or the owner who has left the business, which then goes to his family or other heirs according to his will or according to the distribution provisions in the state intestacy law. This arrangement is much easier to implement for larger companies with a greater number of owners than a cross purchase agreement. There is no need for the owners to have available the means to purchase the interest of a deceased owner when the entity purchase agreement also serves as a buy-sell agreement to the owners’ family members or heirs. That is, the agreement provides that upon the death of an owner, the business is required to buy the business interests from the family members or heirs of the deceased owner.
The downside to an entity purchase agreement is that under many circumstances it may be less tax advantageous to the owner’s family than a cross purchase agreement. In particular, the owners have the actual control over the business’s purchasing terms, so that the owners can make certain that the buy-sell agreement will not adversely affect its business. However, it is the business itself that buys the interest from the owner’s family or heirs. Although the family is still has the ability to control the business by electing officers and directors who then run the day-to-day business, the actual control over the business does not belong to the family because the business is actually owned by the business entity. Rather, the shareholder interest, which confers control over the business, transfers to the survivor or to the family members and heirs. The downside here is that there can be an immediate and substantial tax burden to the estate of the deceased owner. The business entity will have to use its retained earnings (the money of the business), rather than distribute the dividends or other distributions to the owners, to fund the purchase of the deceased owner’s interest. Under federal tax law, the funds the business entity uses to pay for the purchase are treated as dividends to the owners. The payments to the deceased owner’s family or heirs are treated as taxable capital gains to them.

Real-Life Scenarios Illustrating Cross Purchase Agreements

Examples of Cross Purchase Agreements
To give you an idea of how cross purchase agreements work, here are some real-world examples.
When Jane and Joe formed their company, they both agreed to buy life insurance policies on each other’s life. As Jane was the only owner of the company who had the necessary skills to run the company, she also bought a key person policy on Joe because it would be impossible to run the company without him.
Now, fast forward a few years. Joe dies in an accident. All the life insurance proceeds are paid to Jane. Jane then uses the amounts received from the deaths of Joe and the key person policy to buy out the shares owned by Joe’s estate. She pays the estate a fair price for the shares, which is equal to the fair market value. Her life insurance policy and the key person policy have given her the cash she needed to buy her deceased partner’s shares with little or no economic harm to her.
Or consider this scenario: Jack and Jill were partners in an organization and were each equal owners of the partnership. Jill had been diagnosed with a terminal illness and had been given only six months to live. Jack thought it would be a good idea to have a buy-sell agreement in place and have the estate buy Jill’s share of the partnership for fair market value. So, Jack goes to his advisor to get a buy-sell agreement drafted. However, Jill’s illness was so great that Jen did not have any insurable interest anymore in Jill’s life and no buy-sell agreement could be drafted. As a result, Jill’s estate was forced to sell Jill’s shares in the partnership for what Jill’s shares were worth when Jack sold his shares to his wife for fair market value. In the case of Jill who was terminal, the sale of her shares wasn’t planned and it was conducted in a hurry and at a discount, since without an insurable interest there was no leverage for negotiations. The death benefit under the policy would normally create the leverage, but in this case there is no leverage for the negotiation.

Cross Purchase Agreement Expert Insights

As a prudent business owner, it’s important to understand all the different types of agreements you could make with your business partners now to make your relationship easier in the future. We’ve looked at how cross purchase agreements work, so now let’s look at some expert tips and advice for creating one.

• Consider whether an employee buy-in is right for you. Employee buy-ins are one area where it can be worth your time to do some significant research. Be honest with yourself and your business partner about the true value that an employee could offer your company. If your business partner doesn’t see the employee’s perspective of your potential, it may not be the right choice for your company.
• Hire a third party. An attorney can help you sort out the potential issues in your agreement . A lawyer who specializes in business law may be particularly adept at helping you come up with the right language for your agreement. If you think you could go through it alone, it’s important to remember that the potential costs of a poorly constructed agreement far outweighs the costs of getting a good lawyer in the first place.
• Make sure to get things in writing. No matter what may come between you and your business partner, your agreement should be honored in the court of law. In fact, it may be better if your agreement is written in such a way that the law cannot be changed or misconstrued. Sometimes it’s better to have specific numbers in mind and make the decision before the event happens, rather than trying to figure out what the number should be when you are under duress.