Cross-Purchase Agreement

A Cross-Purchase Agreement in the United States records the terms on which a buyer acquires the assets, fixing price, conditions and completion.

The legal basis for a Cross-Purchase Agreement in the corporate context is state corporate law — typically the Delaware General Corporation Law (DGCL, 8 Del. C. § 101 et seq.) for Delaware-incorporated entities, or the California Corporations Code (Cal. Corp. Code § 300 et seq.), New York Business Corporation Law (N.Y. Bus. Corp. Law § 101 et seq.), or Texas Business Organizations Code (Tex. Bus. Orgs. Code § 1.001 et seq.) for entities formed in those states. For LLCs and partnerships, the buy-sell provisions of a Cross-Purchase Agreement supplement the entity's operating agreement or partnership agreement, which may restrict transfers of membership or partnership interests under applicable state LLC and partnership statutes.

The tax analysis of Cross-Purchase Agreements is governed primarily by the Internal Revenue Code. The critical tax advantage of the cross-purchase structure — compared to the entity-redemption structure — is the basis step-up. When a surviving co-owner purchases a deceased owner's interest for fair market value, the surviving owner receives a stepped-up cost basis in the purchased interest equal to the purchase price (IRC § 1012). This higher basis reduces the surviving owner's capital gain when they later sell their interest. Under the entity-redemption structure, the entity's redemption of a deceased owner's interest does not give surviving owners any basis adjustment. For this reason, tax advisors from major accounting firms including Deloitte, PricewaterhouseCoopers, Ernst & Young, and KPMG consistently analyze the relative basis implications of cross-purchase versus entity-redemption when advising closely held business owners.

Life insurance is the standard funding mechanism for death-triggered Cross-Purchase Agreements. Each co-owner purchases a life insurance policy on every other co-owner, naming themselves as beneficiary. The death benefit proceeds are received income-tax-free under IRC § 101(a)(1) and used to purchase the deceased owner's interest. However, the transfer-for-value rules of IRC § 101(a)(2) can cause later transfers of life insurance policies among co-owners to become partially taxable — a trap for the unwary that must be addressed by competent tax counsel when restructuring existing buy-sell arrangements.

A US Cross-Purchase Agreement is needed whenever two or more individuals co-own a closely held business and want to establish binding procedures for the transfer of ownership interests upon specified triggering events, protecting the business's continuity and each owner's economic interests.

A Cross-Purchase Agreement is essential for any partnership, LLC, or closely held corporation with two to five co-owners — the most common business ownership structure for small and mid-sized businesses in California, Texas, New York, Florida, and all other US states. Without a buy-sell agreement, the death or disability of a co-owner can force a sale of the business, create an ownership dispute with the deceased owner's heirs, or result in an unwanted outside party acquiring a co-ownership interest.

The Cross-Purchase structure (as opposed to entity-redemption) is particularly valuable when co-owners have materially different ages or health profiles, because each owner can purchase individually tailored life insurance policies on the other owners rather than having the entity purchase one policy per owner. The individual ownership of policies also avoids the corporate alternative minimum tax (AMT) implications that can affect entity-owned life insurance under IRC § 56(g).

Cross-Purchase Agreements are specifically needed in the following situations: a family business in which siblings or parent and adult children co-own shares and need a mechanism to prevent shares from passing to unwanted family members or spouses upon death; a professional practice (law firm, medical practice, dental practice, accounting firm) in states like California (Bus. & Prof. Code § 16601), Texas, or New York, where professional licensing requirements restrict who may own equity in the practice; a real estate partnership in which multiple investors co-own properties and need a mechanism for buyouts when one investor wants to exit; and any two-owner business where the owners have agreed that the survivor will own the entire business rather than becoming co-owners with a deceased partner's family.

The Uniform Disposition of Community Property Act, adopted in several US states, and community property laws in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin create additional complexity for business co-owners who are married. A properly drafted Cross-Purchase Agreement should address spousal consent requirements to confirm the agreement is binding on the spouse's community property interest in the business.

A complete US Cross-Purchase Agreement must address a specific set of provisions to be legally binding, tax-efficient, and operationally workable. The following elements are essential in any professionally prepared Cross-Purchase Agreement.

The parties and ownership structure section identifies each co-owner by full legal name and states their current ownership percentage. For corporations, it identifies the number and class of shares owned. For LLCs, it identifies the membership interest percentage. For partnerships, it identifies the general or limited partnership interest percentage. This section also identifies the business entity — full legal name, state of formation, and principal place of business.

The triggering events section identifies the specific circumstances that activate the buy-sell obligation. Death and permanent disability (typically defined by reference to a physician's certification of inability to perform material duties for 12 consecutive months, mirroring the disability definition in any funding insurance policy) create mandatory purchase obligations. Voluntary withdrawal, retirement, or termination of employment where ownership is conditioned on active participation typically creates a right of first refusal. Bankruptcy or assignment for the benefit of creditors by a co-owner, divorce proceedings that may transfer interests to a non-owner spouse, and an attempted involuntary transfer (such as a judgment creditor levy) are additional triggering events that most advisors recommend including.

The valuation mechanism section is among the most intensely negotiated provisions. Options include a fixed price updated annually by the owners in a schedule attached to the agreement, a formula based on a multiple of EBITDA or adjusted book value, a two-appraiser process, or a shotgun (buy-sell) mechanism that provides strong incentives for fair pricing. Many practitioners recommend a formula price with an independent certified business valuation (by a CVA or ABV credentialed appraiser) as a fallback if either party disputes the formula result.

The funding provisions section addresses how each purchase obligation will be financed. For death triggers, each owner's obligation is funded by life insurance policies they purchase on each other co-owner's life. The section identifies the insurance company, policy numbers, face amounts, and the procedure for applying death benefit proceeds to the purchase price. For disability and retirement triggers where insurance is unavailable, the section typically provides for installment payments over 3 to 7 years with interest at the IRS applicable federal rate (AFR) published under IRC § 1274(d).

The transfer restrictions section confirms that no co-owner may sell, gift, pledge, or otherwise transfer their ownership interest without first offering it to the other co-owners on the terms specified in the agreement, and that any permitted transfer to a family trust or holding entity must be conditioned on the transferee agreeing to be bound by the Cross-Purchase Agreement.

The life insurance ownership and maintenance section specifies that each owner is responsible for paying premiums on policies they own on co-owners' lives and addresses what happens to policies when a co-owner departs through a non-death event. Transferring a policy to the insured owner at its cash surrender value is one approach, but it may trigger the transfer-for-value rule under IRC § 101(a)(2) — an area requiring specific tax analysis by qualified counsel.