Income Tax Considerations

Premiums Nondeductible

Personally 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 Value

Generally, 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.

Increase in Surviving Owner's Basis

Cross-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.