Cross Purchase vs Entity Redemption Buy-Sell

In a cross purchase buy-sell agreement, the owners personally buy each other out. In an entity redemption, the company buys the departing owner's interest back. The difference looks like paperwork and turns out to be money. A cross purchase gives the surviving owners a step-up in basis and keeps the insurance outside the company. A redemption is easier to run when there are several owners, but it generally gives no basis step-up, and since 2024 it can raise the value of the business for estate tax.

Cross Purchase vs Entity Redemption Buy-Sell, Side by Side

Both structures answer the same question. An owner dies, becomes disabled, retires, or wants out. Who buys the interest, at what price, and where does the money come from? The agreement answers the first two, and life insurance usually answers the third. What changes is who holds the policies.

• Who owns the policies. Cross purchase: each owner owns one on every other owner. Redemption: the company owns one on each owner.
• Basis. Cross purchase gives the buying owners basis equal to what they paid, which lowers capital gains if they go to market later. Redemption generally gives the remaining owners nothing on that front.
• Administration. Cross purchase policy count climbs fast. Two owners need two policies. Seven owners need 42. A redemption needs one policy per owner no matter how many there are.
• Estate tax value. Insurance held outside the company should not add to the company's value. Insurance held inside it does. That is the part that changed in 2024.

How a Cross Purchase Agreement Works

Each owner applies for and owns a policy on each of the others, pays those premiums personally, and is the beneficiary. When an owner dies, the survivors receive the proceeds directly and use the money to buy the interest from the estate at the price the agreement sets.

Because the money comes from co-owners rather than from the corporation, there is no risk of the payment being recharacterized as a dividend to the family. The buyers also pick up basis in what they bought, which can matter a great deal ten years later at a sale. And the proceeds never touch the company balance sheet, so they should not inflate the value of the business for estate tax.

The trade-offs are real. Administration gets heavy past two or three owners. And any time the company, the ownership lineup, or the insurance gets rearranged, transfer-for-value rules come into play. Moving an existing policy, and in some cases even changing a beneficiary, can make a death benefit income-taxable without an applicable exception. Ask your attorney and CPA before anything moves, not after.

How an Entity Redemption Works

The business applies for, owns, pays for, and is beneficiary of a policy on each owner. On a triggering event the company collects the proceeds and redeems the departing interest. One policy per owner, one checkbook, one set of records. It also means the company controls the premiums, so no single owner can quietly break the plan by stopping payment. That simplicity is why redemption has been the default for closely held companies for decades, and why so many older agreements are written that way.

The Compliance Step People Miss

Employer-owned coverage carries a requirement under section 101(j). The business has to give the insured written notice and obtain written consent before the policy is issued, the arrangement has to fit a statutory exception, and the company files a form with its return each year. Miss it and proceeds above the premiums paid can become taxable to the company. The IRS publishes the annual filing requirement. Ask your CPA to confirm the notice and consent were handled at issue, because that piece cannot be repaired later.

There is also a risk for a C corporation that the redemption gets treated as a taxable dividend to the heirs, which shows up most often in family-owned companies. For an S corporation that risk can apply as well. Neither rules out a redemption. Both are reasons to have the agreement read.

What Connelly Changed for Redemption Agreements

On June 6, 2024, the Supreme Court decided Connelly v. United States, 144 S. Ct. 1406, unanimously. Two brothers owned a supply company that owned a policy on each of them to fund a redemption. The long-standing assumption was that death benefit coming into the company was offset by the obligation to buy the shares, netting to roughly zero. The Court rejected the offset. The proceeds count as a company asset for valuation, and the redemption obligation does not reduce it.

The arithmetic in the case shows what that means. The business was initially valued at $3.86 million, the decedent's 77.18% at about $3 million. The company received $3.5 million in death benefit. The IRS and the Court then valued the business at $6.86 million, putting the decedent's shares near $5.3 million. The family received $3 million and paid estate tax on roughly $5.3 million. The additional tax came to $889,914.

This mainly affects owners with taxable estates. An owner well under the federal threshold may still be fine with a redemption, though several states levy their own estate tax and that has to be checked. The agreement in the case was also weak on its own terms: it never set a determinable value, and the annual certificates of agreed value it called for were never completed.

One thing the decision did not do is touch key person coverage. The case turned on whether a buyout obligation offsets value, and key person insurance carries no such obligation. If you hold key person coverage on a general manager, nothing about it became a tax problem in 2024.

The Middle Paths

Wait-and-See

The company gets the first option to redeem, say within 30 days of the triggering event. If it passes, the surviving owners get the next option. If they pass too, the company must redeem. That last step carries the weight, because a pure option to purchase generally will not fix value for estate tax purposes while an obligation can. Wait-and-see gets called the optional buy-sell, which is a misleading nickname without that caveat.

An Insurance LLC

A separate LLC taxed as a partnership owns one policy on each owner, with ownership of the LLC mirroring the operating company. A special allocation clause directs the death benefit to the surviving owners rather than to the decedent's estate. You get cross purchase economics with one policy per owner instead of a web of them, and the insurance sits outside the operating company. The cost is a second entity to form and maintain, plus a named manager, and it does not solve for an owner who cannot qualify for coverage.

How to Choose, and Who Belongs in the Room

No single structure fits everyone. The questions that decide it:

• How many owners are there now, and how many might there be in five years?
• Is any owner's estate likely to be taxable, federally or at the state level?
• Do the owners expect to go to market someday, which makes basis worth real money?
• What entity type is it, and how would a redemption be characterized for it?
• Can every owner qualify for coverage?

The attorney drafts the agreement. Your CPA confirms the tax treatment for your entity. We design and place the coverage and match policy ownership and beneficiary to the structure the attorney lands on. That last part sounds mechanical and is one of the most common problems found in a review. A redemption where the owners personally hold the policies, or a cross purchase where the company holds them, will not do what anyone believed it would. Our strategies for business owners page covers the rest.

Funding Is Where Most Agreements Fall Apart

In the MassMutual Business Owner Perspectives Study from 2022, only one-third of business owners had a buy-sell agreement in place at all, and of those who did, over half may not have been properly funded. The study ties that underfunding to agreements written once and never revisited. An agreement drafted when the company was worth $2 million does not do much for a company now worth three times that.

Permanent coverage handles something term does not. An owner who retires at 68 rather than dying at 52 still needs to be bought out, and the cash value inside a properly designed whole life policy can be part of where that money comes from. We covered buy-sell agreement funding with life insurance in more detail elsewhere.

If your agreement has not been read in a few years, that is worth an hour. You can book a time to talk and bring your attorney and CPA in from there.