A cross-purchase plan is a method to transfer business interests among partners/owners using life insurance policies. The cross-purchase plan is most effective for businesses with relatively few owners. It can be great for commercial real estate brokerages or real estate investment partnerships that have two or three owners.
With a cross-purchase plan, owners agree to buy and sell their respective business interests in the event of death, disability, or retirement.
Using life insurance is one way to fund the buy-out of one of the owners, especially in the event of that owner’s death or disability.
Life Insurance Is Key to a Cross Purchase Plan
I’ll use a simple two-owner business to illustrate this. Let’s say the owners are Bob and Sally. Here’s how it works.
While Bob and Sally are alive and active in the business, they execute a cross-purchase plan. Then Bob buys an insurance policy with Sally as the insured and himself as the beneficiary. And Sally buys an insurance policy with Bob as the insured and herself as the beneficiary. So, if Sally dies, the insurance company pays a death benefit to Bob, and if Bob dies, the insurance company pays a death benefit to Sally.
If one of the owners dies, their interest in the business will pass to their estate or their family by the terms of their will or, if they don’t have a will (which is a really bad idea!), by the laws or probate. This is where the insurance comes in.
Benefits of a Cross-Purchase Plan
The surviving owner uses the insurance proceeds to buy the deceased owner’s interest. This gives the surviving owner full ownership without having to come up with their own cash to purchase the deceased owner’s share.
It has other benefits, too:
- The life insurance proceeds are tax-free. So the surviving owner does not have to pay taxes on the insurance death benefit they receive. The entire amount can be used to fund the purchase of the deceased owner’s share.
- The deceased owner’s share will receive a step-up in tax basis at the time of death, so the surviving owner’s potential future capital gain is limited.
Other Points to Consider
While I’ve couched this in terms of life insurance, this is really an estate planning strategy for business partners who intend to transfer their ownership share to the surviving partner.
I said at the beginning that this is a strategy that can be good for businesses or investment partnerships with two or three owners. That’s because, as the number of owners increase, the number of life insurance policies needed to effect this also increases. With two owners, it requires just two policies. With three owners, it requires six policies. With ten owners, it requires 90 policies. This is because each owner has to have life insurance policies on every other owner. It can get complicated quickly.
The workaround for a business with many owners is an entity purchase plan, which you can learn about in my next post.
As fiduciary financial planners, we at Dominion Financial Advisors do not sell life insurance. But we can recommend insurance agents and insurance plans that fit within your overall financial plan to help ensure that your plan works as intended. Insurance isn’t a separate idea–it’s a key part of a cohesive financial plan. Helping you to create and manage a cohesive financial plan is where we come in.
As a registered investment adviser (RIA) firm, we are legally and ethically required to act as a fiduciary at all times. That means we always must act in your best interest. We have the duty to be loyal to you and to act with care, skill, prudence, and diligence.
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