What is a Cross Purchase Buy-Sell Agreement?
A cross purchase buy-sell agreement is a business structure that is often created when partners seek to prevent unwanted ownership shifts upon the death of one of the owners. The agreement is a legally binding contract between business partners and states that if one of the business owners dies, then his or her share of the business is purchased by the surviving business owner(s). These kinds of agreements are often established when an LLC or partnership is formed , and they require business owners to purchase insurance on each other’s lives. When the time comes to invoke the agreement, the life insurance policy provides the funds necessary to make the purchase.
The agreement essentially operates like a contract, with the terms detailing how and when the transfer will take place. A failure to follow these terms could result in a legal dispute. To prevent this, business owners may wish to consult a business or commercial attorney before crafting the agreement.
Advantages of a Cross Purchase Agreement
One of the primary benefits of a cross purchase agreement is continuity of ownership. The parties to the cross purchase agree to buy each other’s interest in the business and control whether the survivor remains in the business or is bought out. The business can continue without interruption. Another significant benefit of a cross-purchase agreement is financial stability. This process tends to be the most expensive option. The effect is that the survivor is more financially secure with the ability to use insurance proceeds to buy out his or her partners. All surviving partners will benefit from the life insurance policy payouts as well, so the financial stability of the company as a whole dramatically increases. In addition, the much smoother transition will help the company get back on track more rapidly after such a critical blow. A well-crafted buy-sell agreement has a positive effect on business relations. A cross-purchase arrangement is generally deemed to be better for business because it forces the owners to take an active role in discussing the business value and what will happen if one of them dies. Since a cross purchase will increase the value of a partner’s business interest after death, this will normally be in the best interests of the other owner.
Therefore, businesses should consider cross purchase agreements seriously.
Cross Purchase Agreement vs. Entity Purchase Agreement
In a cross purchase buy-sell agreement, the participating owners purchase the business from one another. In contrast, in an entity purchase plan, an entity-often a corporation-or the remaining owners of a business, purchases the business from a departing owner. To illustrate, if James, Scott, and Amy are the three shareholders and shareholders of a C Corporation, James, Scott, and Amy could implement either of the following plans:
• A Cross Purchase Plan: James, Scott, and Amy would enter into a cross purchase plan, which would provide that in the event of the death or disability of one of the shareholders, as determined under a disability plan, the departed shareholder’s interest would be purchased by the surviving shareholders.
• An Entity Purchase Plan: 100% of the stock in the corporation would be owned equally by James (33 1/3%) Scott (33 1/3%) and Amy (33 1/3%). If one of the shareholders died or became disabled under a disability buy-sell agreement, the remaining owners would then purchase the shares of the departed owner from his or her estate. In the case of James’ death, for example, Scott and Amy would purchase the stock of their deceased business partner’s estate and own the corporation in equal shares between them (50%-50%) thereafter.
The choice between using a cross purchase or entity purchase agreement is largely a question of control, convenience and the type of business entity involved.
Convenience: The entity plan is easier to implement since the agreement is between the entity and the parties (i.e., it doesn’t have to include each of the owners). Notably, because the corporation itself owns the two-thirds of the stock that will pass from James and Amy’s estates to Scott and James, from a legal standpoint there’s nothing more to do. The cross-purchase plan, on the other hand, requires James and Amy to arrange a transfer of their business interest after their death to their spouse or perhaps a family member.
Control: If the entity itself owns a 100% piece of property, that is, owns the business property, there would be no problems with transferring the property in the case of James or Amy’s death. This, however, means that the deceased’s stock is being transferred to his or her estate and subsequently to the spouse or his or her estate. This means that James or Amy’s spouse may become an owner in the business, notwithstanding the fact that the parties would have preferred to have the business property, not James or Amy’s stock, go directly to the spouse’s estate. This problem is addressed in most entity purchase plans, however, by first transferring the business property to a limited or general partnership prior to James or Amy’s death so that the spouse’s estate inherits not James or Amy’s stock in the corporation but the partnership interest. The deceased’s spouse would then be able to use the interest in the partnership to satisfy James and Amy’s estate’s obligation under the buy-sell agreement. Since a partnership interest carries with it no voting rights, the spouse would have no control over the company.
Establishing a Cross Purchase Agreement
As with any contract, a cross purchase business succession plan should be thoroughly discussed and understood before entering into the contract. In addition to the mutual agreement reflected in the operating agreement, an independent agreement should be entered into and reflect the key terms of the cross purchase buy-sell agreement among the owners. Unlike a redraft of the operating agreement which may require a vote of approval by the members, however, perhaps only a discussion and general approval among the members is required for a cross purchase buy-sell agreement. This is so because such agreement simply specifies what each member must do at the time of an occurrence of a buy-out event, and the plan itself is not entered into by the operating members until a specific event has occurred. Often, the persons required to enter into the agreement are all known at the time of the execution of the agreement. The cross purchase buy-sell agreement can be set forth in one or more informal documents, though the inclusion of language that specifically provides for the operation of the agreement will provide each member with a clearer understanding of their role and responsibilities under the agreement. For example, the cross purchase buy-out agreement should include at least the following: • The identities of the parties; • A detailed definition of the events that trigger the "buy-sell"; • For cross purchase agreements only, the maximum amounts that the redeeming businesses will be obligated to pay for the purchase of the interest of the member who has suffered the triggering event; and • For cross purchase agreements only, the methodology for evaluation of the interest in the business of the deceased or disabled member and the terms of payment, which will typically be a lump sum payment at the time of the death or disability but may also include provisions for installment payments over several years. (Note: Large insurance premiums might be required in a number of years before the occurrence of a triggering event.)
Challenges to a Cross Purchase Agreement
Cross purchase buy-sell agreements can serve as a useful tool for minimizing conflict, and planning ahead when a person leaves or dies. However, there are many potential obstacles that inhibit their use. Some of these include:
· Failure to fund agreement. After executing a cross purchase agreement, a business is required to purchase an interest from a former partner or shareholder. When this is not financed, the agreement can be rendered useless, as the business is unable to meet its obligations. This can leave the business exposed to unnecessary risk, and can create potential conflicts between owners. (In some cases the business may invest in life insurance policies to fund the buy-sell agreement).
· Partner disagreements . For obvious reasons, partners may not wish to face the death of one of its owners. At the same time, it’s important that the remaining partners are mindful of their current and future needs, as well as those of it being replaced. If this is not balanced, a disagreement may form as to how the final economic rights will be divided.
· Lack of communication. It is essential that all involved parties are kept up to date on the provisions of the cross purchase agreement. Otherwise, they may be in for a shock in the event of a separation. While most businesses do face separation in some form, business owners must be prepared that the conditions of a buy-sell agreement may not apply to every situation (e.g. a partner resignation, retirement, or relocating the form to a new state).
Legal Issues and Considerations
The need for a cross purchase buy-sell agreement does not arise until a lawyer preparing the owners’ estate plans realizes the owners’ death or incapacity requires it. It takes time to draft the agreement, but is equally important to ensure that the owners’ life insurance coverage has been properly collaborated and placed (or put in place subsequently), and that the annual updating of premium rates and insurance beneficiaries is done as necessary over time.
The first legal consideration when drafting a cross purchase buy-sell agreement is making sure that the proper cross owned insurance coverage is in place. The issues discussed above are therefore extremely important to be addressed by those involved. Second, such agreement must be structured in a manner which preserves those legal attributes essential to the enforceability of the cross purchase restriction. For example, the exit restriction drafted in the agreement cannot state that the remaining owners (partners) "will" or "may" purchase the exiting owner’s (partner’s) ownership interest. A legally binding restriction will state "shall" or "must". Third, the manner in which funding is to occur cannot be so detailed that the law would require all owners to make annual updates (i.e., "maximum premiums") or additions to the policy, detrimental to its future use and applicability. Fourth, all taxes associated with the buyout of an owner, for example as a result of the cancellation of policies, must be taken into account when evaluating whether the premium payments are reasonable, considering that insurance debt is not amortized while the insured is alive. Other tax problems are obvious and flow from the drafting and timing issues previously discussed.
The best practice is to utilize the expertise of professional advisors who are familiar with the accurate and effective structuring of a cross purchase agreement.
Examples of Cross Purchase Agreements
Even with plenty of theoretical learning, nothing can quite substitute for real-world case studies when it comes to learning how to effectively utilize cross purchase buy-sell agreements. Let’s look at three such cases.
Case Study 1: School of Excellence
There were time lag and communication problems in a "School of Excellence" where two tenured faculty members were simultaneously killed in a tragic car accident. Both families were caught off-guard, and yes, there was a buy-sell agreement in place, but it was incomplete. The first faculty member’s family received $600,000 from the life insurance policy, along with an extra $100,000 from the firm’s cash reserves. Because the buy-sell agreement didn’t address the second faculty member, there were arguments and legal fees, with the remaining cash reserves eventually going to both families.
Case Study 2: Anderson Consulting
A divorce forced one of the owners of Anderson Consulting to sell his stake in the company for the value of the business . The company was afforded an exception to the general financial, disclosure and confidentiality requirements because all planned payments to the owner were dumped into a "family support account" in which he would receive monthly payments. A lawsuit was brought against the dissolving firm by a third party regarding what constitutes "undisclosed funds." The firm’s defense was ultimately that the divorce had no relation to the company, and the appeal court agreed.
Case Study 3: P.J. Palmer Insurance
A seller in Phoenix, AZ bought the P.J. Palmer Insurance firm, with a large portion of the purchase price coming from a 30-year life insurance policy. The seller sold 100 percent of his interest for $2.5 million. Had the business been structured as a partnership, the buyer would only have received the business’s actual cash value, not its "fair market value." Also, had the policy been exempt from creditor claims, it could have been diverted to the seller himself. However, because the seller paid more than the cash value of the policy ($500,000), the policy was untouchable.