Policies Owned by the Deceased Owner

The agreement should also provide for the surviving owners to purchase from the deceased owner's estate the life insurance policies which he or she had owned on their lives. While other arrangements could be made, it should be noted that transfer-for-value problems could arise for a purchaser if the policies are sold to anyone other than the insured or the business entity.

Ownership Positions

When an owner dies, the typical cross-purchase agreement provides that the ownership interest of each surviving owner remains the same in relation to the other owners. For example, if Grant's ownership interest is twice as great as Lee's before Jackson dies, it will still be twice as great after Jackson's death, as shown by the following example.

After Jackson's death, Grant still has an ownership position twice as great as Lee. However, under a cross-purchase agreement, there is the flexibility to change relative ownership positions if the buy-sell agreement is designed for this purpose. In the above example, it could even be arranged that Lee would purchase all of Jackson's interest, creating a 60/40 ownership position in favor of Grant. This flexibility is not possible with an entity or stock redemption agreement.

Number of Policies Required

The number of policies required under a cross-purchase agreement may be a factor in determining whether such an agreement is feasible. Since each owner must purchase a policy on every other owner, the numbers can quickly add up. Where N equals the number of owners, the number of policies required in a cross-purchase agreement is equal to N x (N - 1). In other words, if there are 6 owners, 30 policies are required (6 x 5 = 30) to avoid a transfer for value (in the case of a corporation) which would occur if 6 policies are jointly owned and policy ownership shifts after an owner's death.

The "Trusteed" Cross-Purchase Agreement

The owners may use a third party, usually referred to as the "trustee," to carry out their obligations under a cross-purchase agreement.

The trustee typically holds the stock certificates (or other evidences of business ownership), and acquires and owns life insurance on each owner. The policy on J would be paid for by K, L, and M; likewise, the policy on K would be paid for by J, L, and M; and so on. Thus, the number of policies is limited to the number of owners when a trustee is used, thus overcoming the problems of (1) a multiplication of policies when several owners are involved in a cross purchase, and (2) a transfer for value when policies are transferred between co-shareholders.

When J dies, the trustee collects the death proceeds of the policy on J. He or she then transfers J's shares to the surviving owners in the agreed-upon proportions, and pays the prescribed proceeds to J's estate. The "trusteed" cross-purchase agreement has enabled J's family to receive a fair price for his interest, and the surviving owners to maintain control of the business.

A potential problem arises when shareholders are involved. When a shareholder dies, the surviving shareholders will succeed to the beneficial ownership of the remaining policies held by the trustee. There has been some speculation that this may be a transfer for value that would cause a forfeiture of the income tax exemption for death proceeds. This problem does not arise for transferee partners, who enjoy an exemption from the transfer-for-value rule.

Selling the Business Interest

As with the entity or stock redemption agreement, the cross-purchase agreement stipulates that any owner wishing to sell an interest during his or her lifetime must first offer it to the other owners.