What Is a Cross-Purchase Agreement?
A cross-purchase agreement is a document that allows a company's partners or other shareholders to purchase the interest or shares of a partner who dies, becomes incapacitated or retires. The mechanism often relies on a life insurance policy in the event of a death to facilitate that exchange of value. A cross-purchase agreement is usually used in business continuation planning, where the document outlines how the shares can be divided or purchased by the remaining partners, such as a proportional distribution according to each partner's stake in the company.
Cross-purchase agreements are a particular type of buy-sell agreement.
- A cross-purchase agreement allows a company's partners or other stakeholders to coordinate continuance of a business.
- The agreement involves the purchase of life and/or disability insurance policy in case a stakeholder dies or becomes incapacitated.
- In the case of premature death, a life insurance policy will allow the other owners to buy out the deceased's shares.
- Where there are multiple partners involved, the complexity of a cross-purchase agreement compounds as policies much be purchased by each with all others involved as beneficiaries.
The Basics of a Cross-Purchase Agreement
A cross-purchase agreement is put in place in the event that shares become unexpectedly available. As a contingency plan for a partner's death, a partner will likely take out term life insurance policies on the other partners and list himself as the beneficiary. If one of the partners dies, the funds from the life insurance policy can be used to buy the deceased's interest.
Due to the structure of life insurance, this transfer of wealth will not be subject to income tax. In addition to being tax-free, life insurance proceeds from a cross-purchase agreement are not subject to creditors’ claims, because the owners of the business are the owners of the policies. Similarly, to prepare for possible incapacitation, a partner would purchase disability insurance.
The third major trigger for a cross-purchase agreement is the retirement of a partner, while more comprehensive agreements contain clauses for the divorce of a partner (to work out legal language for the ex-spouse) or personal bankruptcy situations. Some cross-purchase agreements have a predetermined buyout price, which needs to be updated periodically, while others use a valuation formula or stipulate the hiring of an independent appraiser.
Suitability of a Cross-Purchase Agreement
In most situations where there are just a few partners who are roughly similar in age, a cross-purchase agreement can be ideal. Where there are multiple partners who have to purchase insurance policies on one another, the agreement could become unwieldy. On the other hand, if there are many partners of varying age and health, the agreement could become complex and expensive to implement.
Additionally, if a few of these partners are much younger than the older ones, they will be burdened by higher premium payments on their policies. A solution for a problem of too many partners is consolidating an agreement under a single trustee, which would own policies on each partner, collect proceeds when the time comes, and then distribute the shares to surviving partners.