Buy-Sell Agreements: Information and Resources

For more information, contact:

Vol. I, Issue 11, July 2008

Buy-Sell Agreements: Information and Resources By Ed Sanchez, CLU, ChFC, MBA, MSFS, Advanced Sales Consultant

There is no doubt that planning for life transitions remains a great challenge for most of us. For business owners, the greatest transition is often business succession.

A well thought-out succession plan can answer many questions facing the business owner. Questions such as:

How will my family receive a full and fair value for the business if I die?•If there is an obvious buyer (shareholder, key person, competitor, etc.), where will he/she obtain the funds •with which to purchase the business from me or my estate?

How do I avoid remaining in business with my partner’s heirs in the event that partner dies prematurely? •Where will I obtain the necessary funds to buy him/her out?

A properly drafted buy-sell agreement, funded with life insurance, addresses these questions and creates the cash necessary to ensure that the agreement is completed to the satisfaction of all parties.

The Basics

Normally, a buy-sell arrangement consists of two primary components: 1) a properly drafted written agreement, and 2) the funding mechanism, typically life insurance.

The agreement is prepared by your client’s legal advisor and normally states the purchase price for his/her shares of the business, the terms of purchase, and any funding arrangements.

The agreement obligates either the surviving owner(s) or the business itself to buy and the deceased owner’s estate to sell based on a triggering event such as death, retirement or disability. The business interest may be sold to the surviving business owners, a key employee, an outside party or some combination thereof. The agreement also sets the price or establishes a formula for determining it.

The funding for the arrangement is easily accomplished with the purchase of life insurance on the life of each business owner. Depending upon the structure of the buy-out arrangement, the policies might be owned by the business or by each owner on every other owner’s life. More comprehensive descriptions of these arrangements are available in the resources cited below.

Either term life or universal life may be used to fund the arrangement. Term is most often used for newer companies or those with limited cash flow and universal life for a firm with more predictable cash flow or when owners are also interested in accumulating cash value.

Most business owners want to be sure that their years of hard work are fairly rewarded and that their loved ones receive fair value for their business interest in the event of their death. A properly written and funded buy-sell agreement can help make that happen and also ensure that the business continues uninterrupted in the hands of one or more surviving owners who are best qualified to run it.

Existing buy-sell arrangements should also be periodically reviewed because business and circumstances change over time. Is the agreement funded with life insurance? Is the amount adequate? Is it the appropriate type of product? After all, the most perfect document may not achieve your client’s goal if there is no cash to fund it. Life insurance creates the cash at the precise moment the need arises so that surviving owners and the deceased owner’s family can feel they have been treated fairly and with dignity in the orderly transition of ownership.

FOR PRODUCER USE ONLY — NOT FOR DISSEMINATION TO THE PUBLICcontinued

Advanced Sales Vol. 2, Issue 11, April 2009

MAKERS

MAKERSSales Resources for Buy-Sell Agreements

American General provides a wealth of resources to support the sale of life insurance in conjunction with Buy-Sell Arrangements and other business insurance concepts. Accompanying this article in pdf format are samples of materials that are readily available to you. These include:

An Employer Fact Finder (#AGLC102895) that can be used to identify a variety of business insurance •needs. It is available in Forms Depot which is accessible from our Web site at eStation.aglife.com.

Producer-only educational information on Business Buy-outs from Advanced Markets Online. You •can access these materials from the Sales Tools on our illustration software CD or from our Web site (Marketing/Advanced Sales/Sales Tools).

Consumer-approved information on Business Continuation, Entity Buy-Sell Agreements and Cross •Purchase Buy-Sell Agreements from AMO Salesmaker, a companion program to Advanced Markets Online. You can access these materials from the Sales Tools on our illustration software CD or from our Web site (Marketing/Advanced Sales/Sales Tools).

Note: AMO Documents, a companion software program to Advanced Markets Online and AMO Salesmaker, contains specimen agreements for many business insurance needs. If needed, these specimen agreements can be shared with clients’ attorneys as a general reference. Producers and their clients should not attempt to utilize these agreements without seeking advice of counsel.

Where life insurance is employer-owned, notice, consent, and status requirements of the Pension Protection Act, effective August 17, 2006, must be met by the employer prior to policy issuance in order for the entire death benefit to be received income tax-free. Generally, these require that the key employee be notified of the insurance, and provided other information regarding the insurance, give consent to being insured, and fall within a certain status with the employer, as defined by the Act. For additional information, visit the producer Web site and go to: Employer Owned Life Insurance.

Policies issued by:American General Life Insurance Company2727-A Allen Parkway, Houston, Texas 77019

The United States Life Insurance Company in the City of New York70 Pine Street, New York, New York 10270

The underwriting risks, financial and contractual obligations and support functions associated with the products issued by American General Life Insurance Company (AGL) and The United States Life Insurance Company in the City of New York (USL) are each insurer’s own responsibility. All guarantees are subject to the claims-paying ability of the issuing insurance company. USL is authorized to conduct insurance business in the state of New York. American General Life Companies, www.americangeneral.com, is the marketing name for the insurance companies and affiliates comprising the domestic life operations of American International Group, Inc., including AGL and USL. Policies and riders not available in all states.

Important: Prior to soliciting business, be certain that you are appropriately licensed and appointed with the insurer and that the product has been approved for sale by the insurer in that state. If uncertain, contact your American General Life Companies representative for assistance.

© 2009 American General International Group, Inc. All rights reserved.

FOR PRODUCER USE ONLY — NOT FOR DISSEMINATION TO THE PUBLIC

Discussion guide with business owners

EMPLOYER FACT FINDER

Policies issued by:

American General Life Insurance Company

The United States Life Insurance Companyin the City of New York

Business owners often are too busy to give much thought to planning for their business in the event of their death, disability, retirement, or other unforeseen event. This brief discussion guide can help you focus your meeting on what needs the business owner may have and how you can assist in the planning process—for the future of the business owner, business, and employees.

Company Overview

Business owner ________________________________________________________________________________________________________

Business name ______________________________________________ Nature of business ________________________________________

Address ____________________________________________________ State/Zip code ____________________________________________

Telephone __________________________________________________ FAX _____________________________________________________

Contact e-mail _______________________________________________ Business Web site ________________________________________

What is the legal form of business? Sole proprietorship Partnership LLP LLC S Corp. C Corp.

Current tax bracket? __________________________________________ Number of owners/shareholders? ___________________________

Are owners related? Yes No Indicate family relationships ________________________________

Number of years in business? _________________________________ When does owner plan to retire? ___________________________

What are the business’ goals – short term and long term? ___________________________________________________________________

_______________________________________________________________________________________________________________________

Upon retirement, will the business be: Retained Sold Liquidated

If the business is retained, who would manage it? Spouse Child Key employee Other

If the business is sold, who will buy the business? Key employee Family member Third party

If the business was being sold today, what would be the asking price? ________________________________________________________

Is there a buy-sell agreement in place? Yes No Is it funded? Yes No

How is it funded? _______________________________________________________________________________________________________

What is the agreed-upon sale price? _______________________________________________________________________________________

How was the valuation determined? _______________________________________________________________________________________

What is the source of retirement income? Pension Personal savings Sale of business Have not thought about it

Percent of owner‘s total estate made up by the business? ___________________________________________________________________

In the event of the owner’s premature death, what would happen to the business? _____________________________________________

_______________________________________________________________________________________________________________________

Is there a business succession plan should the owner become disabled? ______________________________________________________

If so, what is it? ________________________________________________________________________________________________________

Will the owner’s salary be continued? Yes No How much? ___________________ How long? ___________________________

Today, what concerns the business owner the most about the business? ______________________________________________________

_______________________________________________________________________________________________________________________

Key EmployeesIn designing benefi t programs for key employees, there are several issues to consider. How the business owner answers these questions will help determine which program(s) might best fi t.

How many employees does this business have? ____________________________________________________________________________

Are any of them “key” to business operations? Yes No How many? ____________________________________________

Is there a qualifi ed plan currently in place? Yes No If yes, what type of plan? ________________________________

Are key employees capped out of their qualifi ed plan? Yes No If yes, what type of plan? ________________________________

Are there any supplemental programs to help retain key employees? Yes No

Types: Executive Bonus Non-Qualifi ed Deferred Compensation Salary Continuation Other _______________________

Details ________________________________________________________________________________________________________________

If the business owner were to increase or provide additional benefi ts, who would the business owner want to benefi t the most? Owner-employees Non-owner employees

With that in mind, which of the following items are most important to the business owner? Please indicate order of importance: (1 – most important; 4 – least important)

_____ Tax deductible to the business ____ Employer control of plan assets_____ Ability to pick and choose who benefi ts ____ Cost recovery

Professional Advisors

Attorney _______________________________________________________________________________________________________________


Telephone __________________________________________________

Certifi ed Public Accountant _______________________________________________________________________________________________


Telephone __________________________________________________

Other Advisor __________________________________________________________________________________________________________


Telephone __________________________________________________

Key Employee Census Hire Birth Tobacco Annual OwnershipKey Employee Name Sex Title Date Date Use (Y/N) Earnings %

Policies issued by:

American General Life Insurance Company2727-A Allen Parkway, Houston, TX 77019

The United States Life Insurance Company in the City of New York70 Pine Street, New York, NY 10270

The insurers of American General Life Companies are solely the providers of the insurance

policy, and their agents, representatives, and employees do not provide legal advice.

American General Life Companies are dedicated to helping clients meet their fi nancial

goals. American General Life Companies, www.americangeneral.com, is the marketing

name of the insurance companies and affi liates composing the domestic operations

of American International Group, Inc., including American General Life Insurance

Company and The United States Life Insurance Company in the City of New York.

© 2009 American International Group, Inc. All rights reserved.

AGLC102895 REV0309

Business Buyouts: Entity Buy-Sell Agreements

What Is a Buy-Sell Agreement?When a business owner dies, the disposition of his or her business interest can become a two-edged sword, creating problems for the business owner's heirs as well as the business itself. Critical questions must be answered:

• Who will purchase the business interest?

• What is a fair price?

• When will the sale be made?

• Where will the funds come from?

This "disposition dilemma" is easily resolved when a buy-sell agreement is established. This agreement provides that:

• someone (e.g., the business entity, the surviving owners, or a key employee) will purchase a deceased owner's interest at an agreed-upon price, and

• the deceased owner's estate is obligated to sell the interest at that price.

The Purpose of Buy-Sell AgreementsFor illustrative purposes, imagine yourself in partnership with two associates. The other two partners are Bob and Elaine. If Bob dies, his business interest passes on to his estate, and ultimately to his wife, Megan. Unfortunately, Megan knows nothing about the business. You and Elaine do not want to form a new partnership with Megan as a business partner, and you don't want Bob's interest sold to an outsider.

It should be added that Bob and Elaine face the same dilemma regarding your heirs. Fortunately, if a buy-sell agreement is in place, none of these potential problems will arise. All the owners know who will receive the deceased owner's business interest as well as how much will be paid for that interest.

A properly drafted buy-sell agreement:

• minimizes the possibility that the business might fall into the hands of outsiders

• minimizes the possibility that the parties involved will not be able to agree on a proper value for the business and puts everyone on equal footing while all the parties are alive

• minimizes the possibility that funds will be unavailable to make the purchase

• provides a deceased owner's estate with needed liquidity by converting an illiquid asset into cash.

It's easy to see why a buy-sell agreement is so valuable. It helps assure business continuity for the surviving owners and fair treatment of the deceased owner's heir(s).

Entity Buy-Sell AgreementsUnder an entity or stock redemption agreement, the business agrees to purchase a deceased owner's interest. To help fund the agreement, the business purchases life insurance on the life of each of the owners; the business owns the policies and is the beneficiary of each policy. The face amount of each policy approximates the purchase price for the insured's business interest. The purchase price is usually set in one of two ways:

• a definite fixed amount is stated in the agreement, or

• a formula is specified by which a definite price can be established.

Graphic: How the Entity Buy-Sell Agreement Works

Cross-Purchase: An Alternative to Entity AgreementsAn alternative to an entity agreement is a cross-purchase buy-sell agreement. Under a cross- purchase agreement, the surviving owners (rather than the business itself) agree to buy the deceased owner's interest. This arrangement is usually memorialized in a written agreement among the owners.

In recent years, the cross-purchase agreement has often been preferred to the entity agreement because the surviving owners in a cross-purchase receive an increase in the basis of their business interests that will reduce their gain upon a later sale of the interest. The survivors receive no such increase in basis when the entity purchases a decedent's interest.

Also, in the cross-purchase agreement, there is no potential for a corporate alternative minimum tax (AMT) liability as there is in an entity agreement. (Note: Recall that the AMT has been repealed for "small corporations" after 1997.)

Click here for a more detailed discussion of the basis issue.

For more about cross-purchase agreements generally, click here.

When the Entity Agreement Is PreferredWhile there are no fixed rules, here are some of the situations where an entity or stock redemption agreement may be preferable to a cross-purchase agreement:

• There are a large number of owners. An entity or stock redemption plan means there is one policy for each owner. Under a cross-purchase agreement, each owner would generally own a policy on every other owner.

• There is a wide disparity in the ages of the owners. A cross-purchase agreement would force younger owners to pay high premiums for policies on the lives of older owners.

• The business wants the cash values of the policies to be available as reserve funds, which would not be possible under a cross-purchase agreement. (If the business uses these cash values the death benefit would be reduced and an owner's untimely death could create financial distress, since loans or withdrawals will reduce the death benefit payable, possibly defeating the purpose for which the agreement was intended.)

Funding OptionsThe insurance professional has two responsibilities when discussing buy-sell agreements:

• establish the need for the agreement, and

• show why insurance products are appropriate for funding the agreement.

The Life Insurance AdvantageAs long as premiums are paid when due and there have not been significant loans or withdrawals, the business may have funds to help purchase a deceased owner's business interest. By contrast, building an investment or reserve fund takes time; if an owner dies "too soon," the business may not have the funds it needs to purchase the deceased owner's business interest.

Taxation of Entity Buy-Sell AgreementsPremiums paid for life insurance used to fund an entity or stock redemption buy-sell agreement are not tax-deductible by the business. Generally, policy death proceeds are exempt from the federal income tax. However, in some situations, a C corporation may be subject to the corporate alternative minimum tax on part of the proceeds it receives. Further, under a corporate stock redemption agreement, there is no increase in basis for a surviving owner's business interest, as there is with the cross-purchase agreement.

Distributions from a corporation to a shareholder are generally taxed as dividends unless a special exception is available under tax law. For the shareholder's estate or heir to avoid dividend treatment, a stock redemption must qualify as one of the following:

• not essentially equivalent to a dividend (a facts-and-circumstances test of limited use in planning),

• substantially disproportionate (a strict mathematical test under which the shareholder's percentage interest in the corporation must decline by specified minimum amounts),

• a complete termination of the shareholder's interest in the corporation, or

• a qualifying partial redemption under Section 303. Click here for more information on 303 redemptions.

If the corporation's distribution in payment of its buy-sell obligation fits one of these categories, the transaction will be treated as the sale of a capital asset and not as a dividend distribution. While most long-term capital gains and dividends now are taxed at the same 15% rate, there will usually be little or no capital gain to report if a redemption is carried out shortly after the shareholder's death, due to stepped-up basis (through 2009).

Stepped-up basis is scheduled to be repealed for one year beginning on January 1, 2010, and then reinstated on January 1, 2011. A limited step-up will be available in year 2010.

Family Attribution RulesThe redemption (unless under 303) will usually terminate the estate's or heir's interest in the corporation. The problem is that the estate or heir may be treated under the attribution rules as constructively owning stock actually owned by others: spouse, children, grandchildren, or parents (and also certain entities such as trusts, estates and businesses). However, assuming all direct interests in the corporation have ceased, including any interest as an officer, director or employee (being a creditor is permitted), the family attribution rules may be waived by filing an agreement with the IRS not to reacquire an interest in the corporation in the next 10 years. This will then allow a redemption to be a "complete termination of interest" despite continuing ownership by close family members.

Note that the entity attribution rules may not be waived.

The Deceased Owner's EstateIf specific requirements are met, a properly drafted buy-sell agreement can establish the value of a deceased owner's business interest for estate tax purposes. However, the value derived from the agreement must approximate the fair market value of the business interest when the agreement is made. Under IRC Sec. 2703, an agreement entered into after October 8, 1990, can establish the value of a closely held business if (1) it is a bona fide arrangement, (2) it is not a device to transfer the business to family members for less than full and adequate consideration, and (3) it has terms comparable to those of arm's-length agreements.

The accumulated case law has created certain additional rules, which apply even if a particular agreement is not subject to IRC Sec. 2703 (e.g., because it was executed before October 8, 1990): (4) the estate must be obligated to sell at an owner's death, either under a mandatory agreement, or under an option held by the business or the surviving owners; (5) the sale price must be fixed by the agreement, either as a dollar amount or by some formula for determining the price; (6) the agreement must prohibit an individual owner from selling his or her interest during life without first offering it to the business or to the other owners at a specified price; and (7) the price set in the agreement must have been fair and adequate at the time the agreement was made.

If the methodology for determining the price is reasonable, it may discourage the IRS from challenging the valuation of the business interest. One thing is certain, however—with no agreement in place, it might take years before an equitable disposition of a business interest occurs. This may mean that the deceased owner's estate cannot be closed and may be subject to erosion through costly delays and possible litigation.

Beyond the Buy-Sell AgreementIn a business setting, it is easy to look at the role of life insurance in terms of how it helps satisfy a contractual requirement.

However, life insurance does more than provide essential funds for the business at a time when the business itself must recover from the loss of a key contributor. It can prevent unnecessary financial strain for the business and the surviving owners. And it can help assure that a deceased owner's heirs are treated fairly.

Copyright © 2006, Pentera Group, Inc., 5546 Shorewood Drive, Indianapolis, Indiana 46220. All rights reserved.

This service is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that neither the publisher nor any of its licensees or their distributees intend to, or are engaged in, rendering legal, accounting, or tax advice. If legal or tax advice or other expert assistance is required, the services of a competent professional should be sought.

While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use of or reliance upon this service.

U.S. Treasury Circular 230 may require The Pentera Group, Inc. to advise you that "any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor."

The Advanced Markets Online materials included in this CD are provided solely as educational information and are for general informational purposes only. These educational materials are for Agent Use Only; Not for Use with the Public. American General Life Insurance Company has not undertaken a substantive review, including the accuracy and reliability, of the materials provided by Advanced Markets Online. Each agent should verify the accuracy and reliability of the information prior to relying on the Advanced Markets Online material. Thus, American General Life Insurance Company shall not be liable for any loss or damage caused or alleged to have been caused by the use of or reliance on the Advanced Markets Online materials by any person. Further, American General Life Insurance Company, its employees, its representatives, and its agents do not provide tax or legal advice. To the extent that any concept discussed in the Advanced Markets Online materials is presented to a customer, the customer must be advised that questions relating to potential tax or legal consequences of the concept should be directed to their own tax or legal advisor.

Business Buyouts: Cross-Purchase Buy-Sell Agreements

What Is a Cross-Purchase Agreement?A cross-purchase agreement is a tool used by business owners to assure that "business as usual" continues if co-owner dies. Like an entity or stock redemption agreement, the cross-purchase buy-sell agreement stipulates that—

• a deceased owner's estate must sell the business interest to surviving owners, and

• the surviving owners will buy that interest.

There are no exceptions—the estate must sell and the survivors must buy.

A cross-purchase agreement also establishes the price to be paid for the deceased owner's business interest. The price is based on: (1) a definite fixed amount stated in the agreement; or (2) a formula by which a definite price can be established. Current tax law has made the second method the more prudent choice in recent years.

Purpose of the Cross-Purchase Buy-Sell AgreementTwo concepts stand at the root of all cross-purchase buy-sell agreements: protection and fairness. A surviving business owner wants to be protected from interference by outsiders when a co-owner dies. Concurrently, a business owner wants to assure fair treatment of his or her heirs in the event of death.

Shareholders and partners use cross-purchase agreements in the same way corporations and partnerships use entity or stock redemption agreements. The distinguishing factor is that, with a cross-purchase agreement, each owner buys a policy on the life of every other owner. Under an entity or stock redemption agreement, the business itself owns a policy on each owner. Click here for more information on entity or stock redemption buy-sell agreements.

Regardless of whether the buyout is cross-purchase, entity, or stock redemption, a properly drafted buy-sell agreement:

• minimizes the possibility that the business might fall into the hands of outsiders

• minimizes the possibility that the parties involved will not be able to agree on a value for the business at the death of an owner

• provides the deceased owner's estate with a ready purchaser for the business interest.

A cross-purchase agreement helps to protect everyone's financial interests, business owners and heirs alike. And funding the agreement with life insurance helps to provide a secure foundation for the agreement.

How the Cross-Purchase Agreement WorksAssume Grant, Lee and Jackson are equal partners in a business with a total value of $450,000, which means each has an interest of $150,000. Under a cross-purchase agreement, agreements are made that at the death of any partner, the other two will purchase his or her interest from the estate.

In our example, Grant and Lee would each purchase a $75,000 face amount policy on the life of Jackson. The total insurance in force on Jackson's life, then, is $150,000—enough to purchase his or her business interest. Similar arrangements are made for each partner.

With a cross-purchase agreement, the individual owners own the policies, pay the premiums, and are named beneficiaries, e.g., Jackson is the insured and Grant is the owner and beneficiary. At the death of one owner, the surviving owners receive the insurance proceeds and use them to purchase the deceased owner's interest from his or her estate.

In the example, if Jackson dies, Grant and Lee each pay $75,000 to complete the buy-sell agreement. Then Grant and Lee each own one-half of the business.

Graphic: How the Cross-Purchase Buy-Sell Agreement Works

Policies Owned by the Deceased OwnerThe agreement should also provide for the surviving owners to purchase from the deceased owner's estate the life insurance policies which he or she had owned on their lives. While other arrangements could be made, it should be noted that transfer-for-value problems could arise for a purchaser if the policies are sold to anyone other than the insured or the business entity.

Click here to jump to a discussion of the transfer-for-value problems. (Then click the "Back" button if you wish to return here.)

Ownership PositionsWhen an owner dies, the typical cross-purchase agreement provides that the ownership interest of each surviving owner remains

the same in relation to the other owners. For example, if Grant's ownership interest is twice as great as Lee's before Jackson dies, it will still be twice as great after Jackson's death, as shown by the following example.

Present Ownership Position At Jackson's DeathGrant 60% 66-2/3%Lee 30% 33-1/3%Jackson 10% —

After Jackson's death, Grant still has an ownership position twice as great as Lee. However, under a cross-purchase agreement, there is the flexibility to change relative ownership positions if the buy-sell agreement is designed for this purpose. In the above example, it could even be arranged that Lee would purchase all of Jackson's interest, creating a 60/40 ownership position in favor of Grant. This flexibility is not possible with an entity or stock redemption agreement.

Number of Policies RequiredThe number of policies required under a cross-purchase agreement may be a factor in determining whether such an agreement is feasible. Since each owner must purchase a policy on every other owner, the numbers can quickly add up. Where N equals the number of owners, the number of policies required in a cross-purchase agreement is equal to N x (N - 1). In other words, if there are 6 owners, 30 policies are required (6 x 5 = 30) to avoid a transfer for value (in the case of a corporation) which would occur if 6 policies are jointly owned and policy ownership shifts after an owner's death.

The "Trusteed" Cross-Purchase AgreementThe owners may use a third party, usually referred to as the "trustee," to carry out their obligations under a cross-purchase agreement.

The trustee typically holds the stock certificates (or other evidences of business ownership), and acquires and owns life insurance on each owner. The policy on J would be paid for by K, L, and M; likewise, the policy on K would be paid for by J, L, and M; and so on. Thus, the number of policies is limited to the number of owners when a trustee is used, thus overcoming the problems of (1) a multiplication of policies when several owners are involved in a cross purchase, and (2) a transfer for value when policies are transferred between co-shareholders.

When J dies, the trustee collects the death proceeds of the policy on J. He or she then transfers J's shares to the surviving owners in the agreed-upon proportions, and pays the prescribed proceeds to J's estate. The "trusteed" cross-purchase agreement has enabled J's family to receive a fair price for his interest, and the surviving owners to maintain control of the business.

A potential problem arises when shareholders are involved. When a shareholder dies, the surviving shareholders will succeed to the beneficial ownership of the remaining policies by the trustee. There has been some speculation that this may be a transfer for value that would cause a forfeiture of the income tax exemption for death proceeds. This problem does not arise for transferee partners, who enjoy an exemption from the transfer-for-value rule.

Selling the Business InterestAs with the entity or stock redemption agreement, the cross-purchase agreement stipulates that any owner wishing to sell an interest during his or her lifetime must first offer it to the other owners.

Using Life Insurance to Fund the AgreementLife insurance is often an appropriate way to help fund a cross-purchase agreement, but this may depend on the health and ages of the owners. Manageable periodic premium payments can help assure the availability of funds for purchasing a deceased owner's business interest, regardless of when the owner dies. If a reserve or investment fund is used, it may take years to accumulate an adequate fund.

Premium PaymentsRegarding premium payments, with a cross-purchase agreement each owner pays for the policies he or she owns. However, premiums can be burdensome for younger owners who must pay for policies on older owners who may also have a larger business interest. There are no rules or guidelines that can be applied in every situation. It may be easier to use an entity or stock redemption agreement so the business itself makes the premium payments.

Split-Dollar Cross PurchaseAn owner could insure another owner whose interest he or she is obligated to purchase by means of a split-dollar arrangement. For example, Alpha and Theta enter into a cross purchase agreement and help fund their respective obligations by obtaining life insurance on each other's life. They enter into split dollar arrangements with their corporation which prescribe a sharing of premiums and death proceeds. Each owner-employee will pay a part of the premium, equal to the economic benefit of the coverage for that year on the insured co-owner. Under a separate agreement, the corporation could bonus out annually an amount sufficient to cover the taxable economic benefit.

When Theta dies, the insurance company pays part of the death proceeds to the corporation as reimbursement under the terms of

the split-dollar arrangement. The balance of the proceeds are paid to Alpha, who uses them to help purchase Theta's interest from his estate. The IRS issued split-dollar final regs in September 2003.

Click here to jump to the discussion of split-dollar final regulations.

Income Tax ConsiderationsPremiums NondeductiblePersonally paid premiums for a cross-purchase agreement are not tax-deductible. If the corporation pays the premiums on behalf of shareholder-employees, the corporation may be able to deduct the premiums as reasonable and necessary compensation, and the shareholder-employees would report that compensation as income.

Transfer for ValueGenerally, the proceeds from a life insurance policy used to help fund a cross-purchase buy-sell agreement are received income tax-free. But if ownership of a policy was transferred for valuable consideration, death proceeds may be subject to ordinary income tax under the transfer for value rules. However, the transfer of a policy to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer is exempt from the transfer for value rule.

Conspicuously missing from the exempt list are transfers to co-shareholders of the insured. So, in the case of a corporate cross-purchase agreement, any sale or transfer for consideration of a policy by the estate of a deceased shareholder should be either to the insured or to the corporation to avoid transfer for value problems later. In the case of a partnership cross-purchase agreement, the estate of a deceased partner should be able to safely sell the policy to the insured, the partnership, or one of the surviving partners.

If a limited liability company is taxed as a pass-through entity, it may be treated as a partnership and its owners as partners for transfer for value purposes, as was the case in Ltr. Rul. 9625013 (see also Ltr. Ruls. 9625019, 200120007). But because a private letter ruling can be relied upon only by the party that requested it, this may not always be the case.

Click here to jump to a more detailed discussion of the transfer-for-value rules and a summary chart of the exceptions to the rule.

Increase in Surviving Owner's BasisCross-purchase agreements provide a distinct benefit with regard to a lifetime sale of a business interest. Assume that you own 50% of ZYX corporation, and the other 50% owner is Jones. You each have a basis of $100,000. When Jones dies, under the terms of your cross-purchase agreement, you purchase his business interest for $200,000. Your basis in the corporation is now stepped-up to $300,000. If you later sell the business for $500,000, you will realize a capital gain of $200,000.

Under an entity or stock redemption agreement, after purchasing Jones' business interest, your basis would remain at $100,000. Thus, if you later sold your business for $500,000, you would have a capital gain of $400,000. The tax bite would be significantly greater under this arrangement.

This discussion does not apply to a partnership, where an entity purchase would result in an increase in basis for the surviving partners. The surviving shareholders of an S corporation using the cash method of accounting could also receive an increase in basis with a properly drafted buy-sell agreement.

Estate Planning ConsiderationsA properly drafted cross-purchase agreement may help to establish the value of a deceased owner's business interest for estate tax purposes if specific requirements are met. The key is for the agreement to meet IRS guidelines and approximate the fair market value of the business interest on the date the agreement is made. Under IRC Sec. 2703, an agreement entered into after October 8, 1990, can establish the value of a closely held business if (1) it is a bona fide arrangement, (2) it is not a device to transfer the business to family members for less than full and adequate consideration, and (3) it has terms comparable to those of arm's-length transactions.

The accumulated case law has created certain additional rules, which apply even if a particular agreement is not subject to IRC Sec. 2703 (e.g., because it was executed before October 8, 1990): (4) the estate must be obligated to sell at an owner's death, either under a mandatory agreement, or under an option held by the business or the surviving owners; (5) the sale price must be fixed by the agreement, either as a dollar amount or by some formula for determining the price; (6) the agreement must prohibit an individual owner from selling his or her interest during life without first offering it to the business or to the other owners at a specified price; and (7) the price set in the agreement must have been fair and adequate at the time the agreement was made.

Capital Gains for HeirsSale of the deceased owner's interest by the executor will have no adverse income tax consequences because of the stepped-up basis provision (through 2009). The deceased owner's original basis is automatically stepped-up to its value for estate tax purposes. Thus, the estate usually realizes no capital gain on the transaction and no income tax is payable.

Stepped-up basis is scheduled to be repealed for one year beginning on January 1, 2010, and then reinstated on January 1, 2011.

A limited step-up is available in year 2010.

Cash ValuesThe cash values of policies owned by the deceased on the lives of other owners are included in the deceased owner's estate. Large cash value amounts could have a significant impact on the size of the estate and thus on the estate tax payable.

Alternative Minimum TaxSince the business does not own the policies used in a cross-purchase agreement, there are no potential corporate alternative minimum tax consequences.

Why Cross-Purchase Agreements Are UsedOne factor that sometimes influences the decision to implement a cross-purchase agreement is that there will be no alternative minimum tax consequences. Thus, if shareholders of a corporation are concerned about preference income and potential tax liabilities, a cross-purchase agreement may be preferred. In addition, the stepped-up basis for surviving owners is an important consideration if owners perceive the likelihood of a lifetime sale of a business interest.

Buy-sell agreements funded with life insurance can be pivotal to the success of a business. The surviving business owners (as well as a deceased owner's estate) receive funds precisely when they are most needed. As an insurance professional, it is your responsibility to work with the client's legal counsel and to know the unique features of each type of buy-sell arrangement to help prepare you to meet each client's needs.

The Wait-and-See Buy-Sell AgreementThe wait-and-see buy-sell agreement is a special type of buy-sell agreement between the owners of a business and the business itself. Unlike the traditional entity buy-sell and cross-purchase agreements, the specific purchaser of an owner's business interest remains uncertain until death, retirement, or disability actually occurs.

Let's assume that we have three shareholders: Tom, Dick and Harry. In the typical wait-and-see buy-sell agreement, this would be the situation at Tom's death:

• The corporation would have a first option to buy Tom's stock from his estate.

• Should the corporation fail to exercise this option, or exercise it only with respect to a portion of Tom's stock, then Dick and Harry would have a second option to buy Tom's stock (or the remainder of it).

• If Dick and Harry should leave any of Tom's stock unpurchased, then the corporation must purchase any remaining portion (or all) of Tom's stock. This assures Tom's family that all of the stock will be purchased, and assures the surviving shareholders that they will succeed to full control of the corporation.

Each of the individual owners and the business entity are potential life insurance buyers. The entity has the greatest exposure since it has a binding obligation to purchase the interest if the two options are unexercised, or incompletely exercised.

The wait-and-see approach is obviously not appropriate for a sole proprietorship or a single-owner corporation. Further, if the owners are related, the family attribution rules are a potential problem in the event of a redemption under the first option, or a mandatory purchase under the third step.

Copyright © 2006, Pentera Group, Inc., 5546 Shorewood Drive, Indianapolis, Indiana 46220. All rights reserved.

This service is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that neither the publisher nor any of its licensees or their distributees intend to, or are engaged in, rendering legal, accounting, or tax advice. If legal or tax advice or other expert assistance is required, the services of a competent professional should be sought.

While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use of or reliance upon this service.

U.S. Treasury Circular 230 may require The Pentera Group, Inc. to advise you that "any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor."

The Advanced Markets Online materials included in this CD are provided solely as educational information and are for general informational purposes only. These educational materials are for Agent Use Only; Not for Use with the Public. American General Life Insurance Company has not undertaken a substantive review, including the accuracy and reliability, of the materials provided by Advanced Markets Online. Each agent should verify the accuracy and reliability of the information prior to relying on the Advanced Markets Online material. Thus, American General Life Insurance Company shall not be liable for any loss or damage caused or alleged to have been caused by the use of or reliance on the Advanced Markets Online materials by any person. Further, American General Life Insurance Company, its employees, its representatives, and its agents do not provide tax or legal advice. To the extent that any concept discussed in the Advanced Markets Online materials is presented to a customer, the customer must be

advised that questions relating to potential tax or legal consequences of the concept should be directed to their own tax or legal advisor.

Wednesday, April 8, 2009CLIENT NAME HERE

A Dilemma…• When a business owner dies, a myriad of potential problems can • occur.• The surviving owners want to retain total control of the business • without interference from the deceased owner’s heirs; they hope • for a prompt transfer of the deceased owner’s interest at a fair • price to the surviving owners; and they want to retain the loyalty • and support of employees, customers and creditors during and • after the transition in ownership.• The deceased owner’s heirs want ongoing financial security after • the loss of the deceased’s salary and benefits; they may • anticipate either retention of the business interest by family • members or a prompt sale of the interest at an attractive price; • and they expect prompt settlement of the deceased’s • estate–including proper tax-valuation of the business interest–if • it’s to be sold.

The Reality…• Conflicts and possibly even litigation might arise between the • deceased owner’s heirs and the surviving owners.• Delays in the transition to successor ownership and in settling the • deceased owner’s estate might be inevitable.• There can be a potential loss of customers, employees, and • creditor confidence that can damage the business–and possibly • even force its liquidation.


The Solution…• A formal, written buy-sell agreement among the business owners • is the first step in assuring an orderly and successful transition in • business ownership following an owner’s death.• The agreement sets a fair price for the business interest and • terms of sale that are reasonable to all parties.• Establishing an agreed-upon price typically sets the value for • estate tax purposes, which helps to avoid estate settlement • delays and IRS challenges.• If the owners are related, a professional appraisal of the business • should be performed. See your legal counsel for advice on this • subject.• An existing buy-sell agreement encourages confidence in the • ongoing vitality of the business in the eyes of customers, • creditors and employees.

The Bottom Line…A properly designed and funded buy-sell agreement satisfies the legitimate concerns of all parties involved in assuring business continuation that benefits sellers, buyers, employees, customers and suppliers.

What the Heirs WantThe deceased owner’s heirs are hoping for ongoing financial security after the loss of the owner’s salary and benefits.

They typically expect prompt settlement of the deceased owner’s estate, including proper tax-valuation of the business interest if it’s to be sold.

They may want to retain the business interest–or to sell their inherited interest promptly at an attractive price.

In the Absence of PreparationIf there’s no formal, written buy-sell agreement among the business owners spelling out what’s to happen when an owner dies, unhappy consequences may result.

Conflicts and possibly even litigation between the deceased owner’s heirs and the surviving owners are not uncommon.

There are typically delays in the transition to successor ownership and in settling the deceased owner’s estate.

Such delays and conflicts can result in a potential loss of customers, employees, and creditor confidence that can damage the business–and possibly even force its unwanted liquidation.

When a business owner dies, the consequences depend to a great extent on the preparation that has been done beforehand in anticipating the event.

What the Surviving Owners Want The surviving owners are typically looking to retain total control of the business without interference from the deceased owner’s heirs.

They may also hope for the prompt sale of the deceased owner’s interest at a fair price to the surviving owners.

They want to retain the loyalty and support of employees, customers and creditors during and after the change in ownership.


The Place for a Buy-Sell Agreement A formal, written buy-sell agreement among the owners of a business is the first step in assuring an orderly and successful transition in business ownership following an owner’s death.

The agreement establishes a fair price for the business interest, and the terms of the sale are set out in advance to be reasonable and agreeable to all parties.

An agreed-upon value for the business interest is typically acceptable by the Internal Revenue Service for estate tax purposes if the value is fair and reasonable, which can help to avoid estate settlement delays and IRS challenges. If the owners are related, a professional appraisal of the business should be performed. See your legal counsel for advice on this subject.

Confidence in the ongoing vitality of the business is generally assured in the eyes of customers, creditors and employees.

Result: A clear solution to a series of knotty problems, thanks to a properly designed and funded buy-sell agreement that satisfies the legitimate concerns of all parties and benefits sellers, buyers, employees, customers, and suppliers.




The Concept…• A buy-sell agreement obligates one party to purchase a • deceased business owner’s interest at a certain price, and • another party–the deceased owner’s estate or heirs–to sell the • interest at that price.• A buy-sell agreement gives business owners assurance about • who will purchase a deceased owner’s business interest, what • the price will be, when the sale will take place, and where the • funds will come from.

The Process…• Under an entity type of buy-sell agreement, the business entity • agrees to buy the deceased owner’s interest. Under another • type–the cross-purchase agreement–each business owner • individually agrees to buy a portion of the deceased’s interest.• The entity buy-sell agreement is funded by life insurance • purchased by the business and covering the life of each owner.• The amount of insurance approximates the purchase price for • each insured’s share of the business.• The purchase price is either specified as a certain fixed amount, • or the agreement includes a formula that will be used to establish • the price.• The business entity owns and is the beneficiary of the policies. If • an owner dies, the business receives the life insurance proceeds, • which it uses to purchase the deceased owner’s interest.


The Choice…• An entity agreement is preferred over a cross-purchase • agreement when there are many owners. The business owns just • one policy for each owner, unlike a cross-purchase agreement • where each owner owns a policy on every other owner.• Entity agreements are also preferred when there is a wide • disparity in the owners’ ages. With a cross-purchase agreement, • younger owners bear a greater premium burden for policies on • older owners.• A business wanting access to policy cash values should choose • the entity type agreement, since that would not be possible under • a cross-purchase agreement.

The Tax Consequences…• Premiums paid for life insurance to fund a buy-sell agreement are • not tax-deductible, but the death proceeds are generally excluded • from federal income tax.• C corporations may be subject to corporate alternative minimum • tax on part of the death proceeds. The inside buildup (in excess • of the cost of insurance) is included in the AMT calculation.• If a corporate stock redemption agreement is used, there is no • increase in basis for a surviving owner’s interest as there is with a • cross-purchase agreement.• Distributions from a corporation to a shareholder are generally • taxed as dividends, but this can be avoided if the stock • redemption qualifies as an exempted transaction–such as a • Section 303 redemption or a complete termination of the • shareholder’s interest.• The price established for a business interest in a buy-sell • agreement can fix the value for federal estate tax purposes if • strict legal requirements are met.


• The price can be based on a professional appraisal or formula • that considers such things as the company’s earnings history and • future earnings potential; the book value of the company’s • assets; the general financial condition of the business; any prior • sales of business interests; goodwill; and the outlook for the • specific industry and the economy in general.

The Bottom Line…A buy-sell agreement funded by life insurance can be an invaluable tool in helping business owners solve three pressing problems: establishing a price for their business interest, and assuring that both a buyer and the money to purchase that interest will be there when the need arises. Choosing the type of agreement–entity or cross-purchase–depends on the business’s own characteristics and the owners’ wishes.

What Is a Buy-Sell Agreement? A buy-sell agreement provides that, if one of the owners of a business dies, a buyer will be available to purchase the deceased owner’s interest, and equally important, the deceased’s heirs will be obligated to sell the interest to the buyer named in the agreement.

The entity type of buy-sell agreement provides that the business entity, rather than the surviving individual owners, will buy a deceased owner’s interest. Another type of buyout–a cross-purchase agreement–provides that each surviving owner purchase a portion of the deceased owner’s interest.

Why Is a Buy-Sell Agreement Needed?A buy-sell agreement helps ensure that a business can continue after an owner dies. When funded by life insurance, the agreement provides both the financing

and the mechanism to ensure that control of the business will remain with the surviving owners and that the heirs will receive a fair price for their inherited interest.

How Does an Entity Buy-Sell Agreement Work?To provide funding for the buyout, the business purchases a life insurance policy covering each owner, with the business entity as the owner and beneficiary. The amount of insurance approximates the agreed-upon purchase price for each owner’s interest.

The agreement stipulates either a specific purchase price or a formula for determining that amount. When an owner dies, the life insurance proceeds provide the funds to buy the interest from heirs.

Premiums paid for the insurance aren’t tax-deductible, but the death proceeds are generally excluded from federal income tax. However, C corporations may be subject to the corporate alternative minimum tax on part of the death proceeds. Redemptions can avoid being taxed as dividend distributions when certain requirements are met.


When Is an Entity Agreement Preferred? The entity buy-sell agreement may be preferable when there are many owners, since it requires only one policy for each. A cross-purchase agreement requires every owner to buy a policy covering every other owner.

An entity agreement may also be the preferred choice if there is a wide age disparity among the owners. Under a cross-purchase agreement, younger owners bear a greater premium burden to insure older owners.

If the business wants policy cash values to be available as reserve funds, it must be the owner of the policy. Access to cash values would not be possible in a cross-purchase agreement where the individual business owners are the policyowners.

What Are the Benefits?With an entity buy-sell agreement funded by life insurance, the business is assured of having the funds to buy out a deceased owner’s heirs, assuring that the surviving business owners will maintain control of the business and the heirs will receive a fair value for the deceased person’s interest. All the terms of the sale including the purchase price, when the purchase will occur, and where the funds will come from, are decided in advance.

In addition, a properly drawn agreement can fix the value of the business interest for federal estate tax purposes.

The benefits are substantial when agreements are made in advance–and in writing–and the apparatus to fund the agreement is in place. The important thing is that owners of small businesses know that they are establishing a fair price for their business interest, and assuring that a willing buyer and a willing seller will be there when the situation arises.





The Concept…• A buy-sell agreement obligates one party to purchase a• deceased business owner’s interest at a certain price, and • another party–typically the deceased owner’s estate or heirs–to • sell the interest at that price.• The agreement gives business owners assurance about who will • purchase a deceased owner’s interest, what the price will be, • when the sale will take place, and where the funds will come from.

The Process…• Under a cross-purchase type of buy-sell agreement, each • business owner individually agrees to buy part of a deceased • owner’s interest. Under another type–the entity buy-sell • agreement–the business entity itself, not the individual owners, • agrees to buy the interest.• To fund a cross-purchase buyout, each owner purchases a life • insurance policy covering the life of every other owner. Added • together, the policies insuring each owner total the purchase • price for that owner’s share of the business.• The purchase price is either specified as a certain, fixed amount, • or the buy-sell agreement provides a formula that will be used to • establish the price.• Example: Three partners own equal shares in a business valued at• $300,000, with each owner’s share worth $100,000. To fund a cross-• purchase agreement, Owners 1 and 2 each purchase a $50,000 • policy covering Owner 3. Owners 2 and 3 each purchase a $50,000 • policy covering Owner 1. And Owners 1 and 3 each purchase a • $50,000 policy covering Owner 2. The result is two policies covering • each owner, for a total of six policies.


• In a cross-purchase agreement, each owner/partner owns the • policies he or she buys covering the lives of the others, and is the • beneficiary of those policies.• If an owner dies, the surviving owners use the life insurance • proceeds to purchase a share of the deceased owner’s interest.

The Result…• Cross-purchase agreements generally provide that each • surviving owner’s interest in the business remains the same in • relation to the other owners. So if the relationships are unequal, • they remain unequal after the death. • Example: Ash owns 60 percent, Birch owns 30 percent and • Cedar owns 10 percent of their company. If Cedar dies, Ash’s • interest is still twice that of Birch. With Cedar’s 10 percent interest • divided pro-rata between the two survivors, Ash’s ownership • grows from 60 to 66 2/3 percent, and Birch’s from 30 to 33 1/3 • percent.

The Tax Consequences...• The life insurance premiums each owner personally pays are not • tax-deductible. • In another scenario–if a business corporation pays the premiums • on behalf of shareholder-employees–the corporation may be able • to deduct the premiums as a reasonable and necessary business • expense if the payments can be treated as salary rather than • dividends. But the shareholder-employees must still report these • amounts as income, either as compensation or as dividends.• If the amounts coming from the corporation are treated as • dividends, the business can’t deduct them.• The policy owner uses the proceeds to buy the deceased owner's • interest.


• The surviving owners receive an increase in basis under a cross-• purchase agreement that isn’t available in an entity or stock • redemption agreement. A basis increase is desirable because it • reduces the amount of taxable capital gain upon a future sale of • the business interest.• Any cash value in policies the deceased person owned covering • the other business owners is included in the deceased owner’s • estate, which could affect the estate tax payable.• The purchase price established in a buy-sell agreement can fix • the value for federal estate tax purposes if strict legal • requirements are met. • The price can be based on a professional appraisal or formula • that considers such things as the company’s earnings history and • future earnings potential; the book value of the company’s • assets; the general financial condition of the business; any prior • sales of business interests; goodwill; and the outlook for the • specific industry and the economy in general.

Potential Downsides…• In a business with many owners, a cross-purchase agreement • can be cumbersome because of the number of policies required. • For example, with six owners, each owner purchases a policy • covering each other owner, for a total of 30 life insurance policies • needed to fund the agreement.• If there’s a wide disparity in the owners’ ages, the younger • owners carry the greater premium-payment burden since the • older owners’ policies cost more.• The business itself can’t use any cash values that may • accumulate in the policies since the individuals, not the business, • own the policies.


The Multiple-Policy Solution…• To avoid the multiple-policy problem, owners may use a • “trusteed” cross-purchase agreement.• In this situation, the trustee purchases and owns life insurance on • each owner, reducing the number of policies to the number of • owners. The trustee collects the policy proceeds when an owner • dies, pays the proceeds to the deceased owner’s estate, and • transfers the deceased owner’s shares to the surviving owners in • the agreed-upon proportions.• The trusteed arrangement works only if the owners are partners • in a partnership. Otherwise, the transfer-for-value rule will apply • to taint the death benefits after the first death.

The Bottom Line…A buy-sell agreement funded by life insurance can be an invaluable tool in helping business owners to establish a price for their business interest, and to assure that both a buyer and the money to purchase that interest will be there when the need arises. Choosing the type of agreement–cross-purchase or entity–depends on the business’s own characteristics and the owners’ wishes.

What Is a Cross-Purchase Buy-Sell Agreement?A buy-sell agreement provides that, if one of the owners of a business dies, the other owners will purchase the deceased owner’s interest, and equally important, the deceased’s heirs will be obligated to sell the interest to the other owners.

The cross-purchase type of buy-sell agreement provides that each surviving owner individually will purchase a portion of the deceased owner’s interest. Another type, where the business and not the individual owners buys the deceased’s interest, is called an entity agreement.

Why Is It Needed?A buy-sell agreement helps ensure that a business can continue after an owner dies. When it’s funded by life insurance, the agreement provides both the financing and the mechanism to ensure that control of the business will remain with the current owners, and the heirs will receive a fair price for their inherited interest.

How Does It Work?To provide funding, each owner buys a life insurance policy covering the life of every other owner. Each person owns the policies he or she buys and is the beneficiary of those policies.

Assume a partnership valued at $750,000 is owned by three equal partners–Risley, Radford and Wisman. With a cross-purchase agreement, each partner buys policies on the lives of the other two in the amount of $125,000 each, so that each partner is insured for a total of $250,000.

Assume further that Wisman dies. The death benefit on the two policies insuring his life–one owned by Risley and one by Radford–is paid to the two surviving partners as beneficiaries of the policies. Result: the surviving partners have a total of $250,000 to purchase Wisman’s business interest from his heirs.

What’s the Tax Picture?The premiums individual owners pay are not tax-deductible. If, on the other hand, a corporation pays the premiums, they may be deductible, if they’ll be treated as compensation to the shareholder-employees on whose behalf they are paid. If the corporation’s premium payments are treated as dividends to the shareholders, the premiums would not be deductible by the corporation but could qualify for the special 15 percent tax rate on corporate dividends paid to individuals.


Life insurance death proceeds are generally received federal income tax-free.

What Are Some Other Benefits?With a cross-purchase buy-sell agreement in place, surviving owners are assured of having the funds to buy out a deceased owner’s heirs and maintain control of the business.

While all the terms of the sale are decided in advance, the agreement should provide a mechanism—such as a periodic stock revaluation clause—so that the heirs receive a fair price for the deceased's interest.

The surviving owners receive an increase in basis that can reduce the capital gain taxes on any future sale of the business interest.

Finally, a properly drawn buy-sell agreement can fix the value of the business interest for federal estate tax purposes.

What Are Some Potential Downsides?A cross-purchase arrangement may be cumbersome when there are many owners, since multiple life insurance policies are required. For example, a business with six owners would require a total of 30 policies to fund the agreement (unless a trusteed approach is used).

When there is a wide age disparity among the owners, younger owners bear a greater premium burden to insure older owners because of the higher premiums required at higher ages.

Cash values accumulating in the policies aren’t available to the business itself,since the policies in a cross-purchase agreement are individually owned.

Both the pluses and minuses should be considered in determining what type of agreement to put in place. The important thing is that, with any type of properly drawn-up and funded buy-sell agreement, owners of small businesses know that they are establishing a fair price for their business interest, and assuring that the people and the money to purchase that interest will be there when the situation arises.


