Entity vs Cross-Purchase Buy-Sell Agreement

Entity Buy-Sell Agreement

A business succession plan that utilizes the life insurance buy-sell contract has two primary forms. When the business itself is the owner and beneficiary of a life insurance contract on each owner this is known as an entity agreement. Upon the death of one of the owners, the business would claim and collect on a insurance contract valued in accordance with the deceased partners value of interest owned. The business would then use that money to purchase the deceased partner’s interest from their estate, allowing the surviving partners to retain control of their company. Upon receipt, the transferred business interest would be equally split between all remaining partners. This method of succession was most commonly used when the business wanted to minimize the number of policies necessary because of the high number of individual owners.

The entity agreement plan in the modern day presents two problems. In June of 2024 the U.S. Supreme ruled on a case Connelly v. The U.S. altering how these agreements would be taxed in a major way. Prior to this ruling, the money receipted by the business for the express purpose of re-purchasing interest was not considered as an asset to the business. The deceased partner’s estate would however have to include the value of the policy in the estate tax calculation. The 2024 ruling reversed this precedent, allowing the IRS to include the death benefit as an increase in valuation of the business. This now means that not only does the estate of the deceased pay estate taxes on the policy, but the funds then increase the value of the business by the same amount, which in turn increases the taxable estate of the deceased owner. The entity buy-sell agreement essentially doubles the estate tax implications of an owner.

The second problem with the entity agreement also deals with taxation. In a LLC (C-schedule) or fully incorporated business, a distribution of business interest is usually considered a dividend. This means that the act of re-purchasing and distributing shares would be taxed as a dividend to the business and the surviving owners. There are a few exemptions for different types of corporations, consulting with a good CPA is integral to an efficiently structured entity plan.

Cross-Purchase Agreement

The alternative succession structure using a buy-sell contract is the individual owners, not the business, being the beneficiaries of contracts issued on each other. Upon the death of an owner, the contract pays out a death benefit directly to the surviving owners in amounts appropriate to purchase the deceased’s interest from the estate. This structure can be more complicated in that it requires multiple separate transactions. Each owner would need a plan on each other, and then in the event of a death, need to handle separate claim processing. The amount of owners the business has is a major factor when considering this buy-sell agreement structure.

In a cross-purchase agreement the contract will be included in the estate of each owner, and will be paid for with after-tax dollars. The death benefit however will not add to the valuation of the business or be treated as a dividend payment, and it will be income tax free to the recipient surviving owner. When tax mitigation is a primary concern, the cross-purchase agreement is the most commonly used succession structure.