Cross-purchase vs entity redemption buy-sell plans

In a cross-purchase buy-sell, the surviving owners buy the deceased owner's interest and own the life insurance on each other. In an entity-redemption buy-sell, the business buys the interest and owns the policies. Entity redemption is simpler to run, but since the Supreme Court's June 6, 2024 decision in Connelly v. United States, company-owned insurance on a shareholder can raise the company's estate-tax value, which pushes many owners to re-examine cross-purchase or a hybrid.

How each structure works

Cross-purchase. Each owner buys, owns and pays premiums on a policy on every other owner. When an owner dies, the others collect the proceeds and use them to buy the deceased owner's interest from the estate under the agreement. The surviving owners end up with a larger share, and the estate gets cash.

Entity redemption. The business buys, owns and is the beneficiary of a policy on each owner. At death, the business collects the proceeds and redeems the deceased owner's interest. Ownership percentages of the survivors rise proportionally because the redeemed shares are retired or held in treasury. A corporation is the typical redeeming entity, and an LLC or partnership can do the equivalent as a liquidating or redemption transaction.

A hybrid or wait-and-see agreement gives the company or the owners an option to buy at death, with one acting first and the other filling the gap. It buys flexibility, but gives up certainty about the structure until the day it matters.

Side-by-side

The basis point

Under a cross-purchase, surviving owners buy the shares at the price they pay, so their tax basis in the acquired interest equals what they paid. Later, when they sell the business, the gain is measured from that higher basis. Under a redemption, the business pays and the survivors' own basis does not increase. For a closely held business with a high expected sale price, that can be a meaningful difference. The effect depends on entity type, state tax and facts, so have a CPA model it. An S corporation, partnership or LLC taxed as a partnership each has its own mechanics.

What Connelly changed

Connelly and his brother owned Crown C Supply under an agreement that let the survivor buy the deceased brother's shares and, failing that, required the company to redeem them. Crown owned life insurance on each. After one brother died, the company used part of the $3.5 million proceeds to redeem his shares. The estate said the company was worth $3.86 million, excluding the proceeds. The IRS counted the proceeds and arrived at $6.86 million. The Supreme Court unanimously affirmed in the IRS's favor, holding that a corporation's obligation to redeem shares at fair market value is not a liability that offsets the insurance proceeds in valuing the company (opinion).

The opinion also pointed out that a cross-purchase agreement, with the surviving brother owning the policies, would have avoided the problem, while noting the costs of that structure. It left room for situations where a redemption obligation forces the sale of operating assets and so reduces the company's value.

What it means for choosing between the two structures:

• If the estate is large enough to face federal or state estate tax, company-owned insurance on a controlling shareholder may increase the taxable value of the stock. For smaller estates it may matter little at the federal level, although state taxes vary.
• A cross-purchase, or entity-redemption with a different ownership design, can avoid pushing the proceeds into the company's value.
• Existing agreements are not automatically wrong. They need a valuation review with an attorney and CPA, and perhaps a restructuring, which can cause its own tax consequences.

When each tends to make sense

Cross-purchase tends to suit:

• Two or three owners with similar ages and similar interests.
• Owners who want a basis increase and creditor protection for the policies.
• Estates where Connelly exposure is a concern.

Entity redemption tends to suit:

• Many owners, where n × (n − 1) policies is unworkable.
• Owners with widely different ages or ownership, where equal premiums would be unfair.
• Situations where state law and corporate cash flow permit redemption, since corporations may be restricted from redeeming shares when they would become insolvent.

For many-owner companies, a trusteed cross-purchase or an insurance LLC holds one policy per owner and avoids the policy explosion, and it can keep the proceeds outside the company. These structures need careful drafting. A transfer of an existing policy can trigger the transfer-for-value rule in IRC 101(a)(2), which can make part of the death benefit taxable unless an exception applies, such as a transfer to the insured or to a partner of the insured. The exceptions are technical, and an attorney should review any policy transfer.

A worked example (hypothetical)

Say two partners, ages 45 and 58, each own half of a Colorado landscaping corporation worth $4 million. Each interest is $2 million. Under cross-purchase, the younger partner buys a $2 million policy on the older partner, and the older partner buys a $2 million policy on the younger. The younger partner's policy on the 58-year-old costs much more per $1,000 than the policy the older partner holds on a 45-year-old. The younger partner may bargain for a compensation or bonus adjustment to even it out. Under entity redemption, the company pays both premiums, which evens the burden but puts the policies in the company, raising the Connelly concern if either estate is large enough to face estate tax. A trusteed cross-purchase or another structure might solve both problems. The buy-sell agreement funding calculator shows premium and face-amount scenarios; these numbers are only illustrative.

Questions to settle before choosing

1. How many owners are there now, and how many will there be in 10 years?
2. What are the ages, health and ownership percentages?
3. How large are the owners' estates relative to current estate tax exemptions and any state estate or inheritance tax?
4. What is the entity type, and what does the CPA say about basis and tax on the redemption?
5. Does state law restrict the company's ability to redeem?
6. What happens on disability, divorce or retirement, not just death? See disability buy-out insurance: funding a buy-sell when an owner is disabled.
7. Does the company have any key person policy that must be kept separate from the buy-sell funding? See key person insurance: protecting the business from a loss of talent.

For policy underwriting and employer-owned rules, see how insurers underwrite business life insurance and Employer-owned life insurance: notice and consent rules under IRC 101. For the full funding discussion, read Funding a buy-sell agreement with life insurance after Connelly.

Key takeaways

• Cross-purchase puts the policies in the owners' hands and gives survivors a cost basis; entity redemption puts them in the company and is simpler with many owners.
• Connelly v. United States (June 6, 2024) held that a company's obligation to redeem shares does not offset the insurance proceeds in valuing it for estate tax.
• Policy count is n × (n − 1) in a cross-purchase, so a trusteed cross-purchase or insurance LLC is common for more than three owners.
• Moving or restructuring policies can trigger the transfer-for-value rule, so involve an attorney and CPA before changing anything.