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What is a cross-purchase agreement? • The insurance pro blog

If you own a business, you need a clear template for your buy-sell agreement that describes the triggering events, how you will finance it, the agreed value of the business and the structure of the event [19659002]. But what is even more important is that you must be sure that you are financing the contract with life insurance that is not paid from the company's checkbook. You can roll the dice, ignore the problem completely and just do business with your partner's wife when they die, but I've seen this happen on several occasions – not pretty.

Most people who have experience with this situation would liken it to water-boarding, it will not kill you but it will surely make your life miserable.

Many business owners who have not financed their buy-sell agreement fail to do so because they fear the cost of the life insurance policies needed to properly finance the agreement. But this should not be a reason to delay the purchase, in fact, the cost of a financed buy-sell (life insurance premium) is peanuts compared to the benefit it provides.

And without one, a family business or a close-knit business can have serious financial and tax problems after the death of an owner. Life insurance premiums are much cheaper than the potential financial pain.

What is the advantage of a buy between buy and sell between buy?

Understand that the legal document that describes a buy between buy and sell between buy is very specific and detailed. As such, we are trying to offer an accessible explanation at a high level and we do not want to explain all the many legal aspects. The only buy-sell discussion here is the overbought agreement.

This is the most basic type of agreement and it is a good place to build your basic knowledge on the subject. It is also the most common buy-sell agreement we have seen in more than 20 years.

Overview of a basic cross-purchase plan

In a basic cross-purchase agreement, when a business owner dies, the surviving owners agree to buy the deceased owner's shares in the business. Each owner agrees to buy the interests of others if one of the owners dies.

So in this scenario, each owner is an applicant, a premium payer, a beneficiary and an owner of life insurance for each of the other business owners.

There is an image below with an example to help you sort everything out for yourself.

When an owner dies, each surviving owner / beneficiary will receive the insurance death benefit. Each surviving owner then pays cash to the deceased owner's property or family (depending on how the agreement is drawn up) and in exchange, the farm transfers the deceased owner's shares in the company.

What is the result that the family's illiquid shares in the company are magically transformed into cash and the owners who are still alive own the entire business. Everyone wins, the family of the deceased owner receives cash and the surviving owners of the company are not forced to do business with the deceased owner's family.

What is the structure of the agreement?

Let's use Bob and Sam as our example. They own the XYZ Magic Button company.

  1. Bob and Sam make a cross-purchase agreement between them.
  2. Bob and Sam apply for a life insurance on each other. Each of them is the owner, beneficiary and premium payer of an insurance policy in the other's life.
  3. Let's assume Bob dies, the life insurance company pays Sam the death benefit.
  4. Bob's shares in XYZ are transferred to his property / family.
  5. Bob's property / family sells their shares to Sam according to the predetermined overbought agreement.
  6. Sam uses the life insurance proceeds to pay Bob's family cash for Bob's shares in XYZ.
  7. Now Sam owns 100% of XYZ Magic Button Co.

Here is a picture to illustrate how it happens.

  Graphic explanation of a cross-purchase sales agreement

Establishing a value for the business

This is one of the most important aspects of the agreement, Sam and Bob have to sit down and set a value for his company. In order for the two to be sure that the arrangement is properly financed, they must both have sufficient life insurance coverage for each other until the "date of death" for the deceased owner's shares. There are several ways for them to arrive at a business valuation:

  • A valuation value – which is determined by an independent assessment at the time when the business interest is actually sold
  • Capitalized profit method – the value is determined by an income-based model. It derives the value of the business by dividing the selling party's discretionary earnings by the capitalization rate.
  • Specific fixed price – the owners determine the price regularly according to agreement
  • Formula value – determined formula consisting of several factors that the owners agree to in the cross-acquisition
  • Book value – the actual book value of the owners' shares at the date of death

What is the advantage of a cross-purchase plan?

Well, in addition to the obvious benefits that I have already discussed, there are others that are much more concrete in nature. If Bob dies and Sam buys all of Bob's shares under the cross-purchase agreement they had in place, Sam will receive a cost increase base for the acquired shares that corresponds to the entire purchase price.

This is very good for Sam. If he later decides to sell the entire XYZ Magic Button Company, at least half of his shares will have a much higher cost base that reduces capital gains.

There are also at least two other benefits. which are related, the company is not at all involved in the buy-sell agreement in any official capacity, which means

  1. The business is not forced to reflect the value of the life insurance in the balance sheet. This would lead to an increase in the value of the business.
  2. As the business is not a party to any of the transactions, the life insurance is not subject to the calculation of the alternative minimum tax (AMT).

Are there any disadvantages?

There are a few things that can complicate things and make a purchase agreement that is not so great.

  1. If there are too many owners, there can quickly be an obscene number of policies that must be purchased for the agreement to work. The formula for calculating the number of policy needs is N (N-1), where N is equal to the number of owners. Example: If there were five owners, 20 insurances would have to be bought … seriously? It's a little out of hand.
  2. The owners could violate the rules of transfer of value, to finance subsequent acquisitions, the estate property transfers all remaining insurance to the surviving owners. But there is much more that I just can not get into here because it is a topic in itself.

Ultimately, it is always best if you have a competent lawyer and / or tax advisor involved in the decision-making process the right type of buy-sell agreement that your company should have. But if you have a small business with two owners, the buy-sell agreement between several purchases is probably your best choice.

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