Understanding the Cross-Purchase Structure and Why an Insurance Trust Owns the Policy
A cross-purchase agreement is a buy-sell arrangement under which the business owners agree that, upon a triggering event such as death, disability, or retirement, the surviving owners will purchase the departing owner’s interest. Using an irrevocable life insurance trust to own the life insurance intended to fund the agreement introduces additional protection and tax efficiencies, but it also adds layers of legal and tax complexity. The trust must be carefully drafted to hold the policy, receive proceeds, and deploy those proceeds in a manner that satisfies both the buy-sell contract and the Internal Revenue Code.
Laypeople often assume that simply obtaining life insurance is sufficient to “fund” a buy-sell arrangement. In practice, the details matter tremendously. Ownership of the policy, beneficiary designations, premium funding methods, applicable state law, and coordination with the operating agreement or shareholders’ agreement all influence whether the arrangement will actually perform as intended. An improperly designed structure may trigger transfer-for-value income tax issues, cause loss of S corporation status, produce unintended gift tax exposure, or lead to contested ownership and valuation disputes at the worst possible time.
Using a trust to own the policies can deliver creditor protection, centralized administration, and estate tax mitigation. However, the trust must be aligned with the cross-purchase agreement’s terms and funding mechanics. The trustee’s powers, fiduciary duties, Crummey withdrawal rights, and valuation provisions must be precisely delineated to avoid conflicts with the buy-sell obligations and to ensure the insurance proceeds are used for the mandated purchase without adverse tax consequences.
Selecting the Right Trust: Why an Irrevocable Life Insurance Trust Is Usually Preferred
An irrevocable life insurance trust (ILIT) is typically used when the objectives include keeping insurance proceeds outside the insured owner’s taxable estate, protecting proceeds from creditors, and managing the flow of funds to the purchasing owners. In a cross-purchase structure, each owner’s ILIT often owns a policy on the lives of the other owners, or a single ILIT may be used by a group of owners where state law and tax rules permit. The trust’s irrevocable nature helps ensure estate tax exclusion and prevents retained incidents of ownership from inadvertently pulling the policy back into the estate.
While a revocable trust may offer simplicity, it rarely delivers the same tax results. Retained powers in a revocable arrangement can cause inclusion of policy proceeds in the grantor’s estate and undermine creditor protection. Additionally, the revocable trust may complicate premium gifts, Crummey powers, and generation-skipping planning. These nuances are often overlooked until a triggering event occurs, at which point it is too late to correct structural deficiencies without litigation or significant tax cost.
Selecting the ILIT format requires careful attention to grantor trust status for income tax purposes, the appointment of an independent trustee, and the scope of trustee powers to purchase, hold, and dispose of the insured’s business interests. Each of these decisions has downstream implications for basis step-up, valuation, and the eventual disposition of interests acquired by the trust when the buy-sell closes.
Defining the Parties: Insureds, Policy Owners, Beneficiaries, and Purchasers
In a cross-purchase funded by an insurance trust, the identities and roles of the parties must be unambiguous. The insured is the business owner whose death or disability triggers the buy-sell obligation. The policy owner is commonly the ILIT established by the purchasing owner or owners, and the beneficiary is the ILIT itself. The purchasers under the buy-sell are the surviving owners (or their trusts), who are obligated to acquire the deceased owner’s interest from the estate or a designated seller under the agreement.
Ambiguity around ownership and beneficiary designations is a frequent source of litigation. Policies mistakenly owned by the insured’s revocable trust, incorrectly designated beneficiaries, or beneficiary changes executed without cross-reference to the buy-sell agreement can invalidate the funding plan. Moreover, when owners are married or reside in community property states, additional consents and spousal acknowledgments may be required to prevent later arguments that the policy or the business interest is subject to marital claims.
To reduce these risks, the agreement should include explicit schedules identifying the insureds, policy numbers, owners, premium sources, and beneficiaries, and it should require trustee and spousal consents where applicable. The trust instrument should authorize the trustee to receive and apply proceeds to consummate the purchase and to hold, distribute, or sell acquired interests in accordance with fiduciary duties and tax objectives.
Coordinating the Cross-Purchase Agreement with the Trust Instrument
The buy-sell agreement and the trust document must be drafted in tandem. The agreement should mandate that policies be owned by the designated trust and that the trustee use proceeds to satisfy purchase obligations. The trust should mirror this directive by granting the trustee authority to enter into and perform the cross-purchase, including the power to value, purchase, and hold closely held business interests, and the power to borrow or pledge trust assets if liquidity is temporarily insufficient.
Discrepancies between the documents can be disastrous. If the buy-sell permits policy proceeds to be used for discretionary distributions rather than mandating their use for the purchase, the trustee may face competing demands from trust beneficiaries and the purchasing owners. Conversely, a trust lacking express authority to complete the purchase can render the funding mechanism ineffective, requiring court intervention. Harmonization of defined terms, trigger events, and valuation mechanisms across both documents is essential.
Include integration clauses that reference the cross-purchase agreement in the trust and vice versa. Provide a conflicts provision stating that the buy-sell controls funding obligations while preserving trustee discretion on investment and administration consistent with fiduciary duties. This balance prevents the trustee from being forced into imprudent transactions while ensuring that the core promise to purchase is kept.
Premium Funding: Gifts, Loans, and Crummey Powers
Most ILITs are funded through annual exclusion gifts that the trustee uses to pay premiums. To qualify gifts for the annual exclusion, the trust commonly grants beneficiaries Crummey withdrawal rights and the trustee sends timely written notices. Failure to properly deliver and document these notices is a pervasive error that may convert otherwise excluded gifts into taxable gifts, disrupting the entire funding strategy and potentially consuming lifetime gift and estate tax exemption needlessly.
Premium payments may also be structured as loans, particularly where the grantor prefers to retain flexibility or where annual exclusions are insufficient. If loans are used, the trust instrument and buy-sell agreement should recognize the loan structure, document interest rates, repayment terms, and security interests, and address what occurs if the insured dies while loans are outstanding. Failure to document loans can trigger imputed interest, gift recharacterization, and disputes among beneficiaries and purchasing owners.
Split-dollar life insurance arrangements can be considered to manage premium costs, but they introduce additional regulatory layers and reporting. If used, the buy-sell and trust documents must specify ownership, economic benefits, termination rights, and the allocation of death benefits. Coordination with experienced counsel and a CPA is crucial, as minor drafting errors can create substantial income and gift tax exposure.
Triggering Events and Mandatory Purchase Provisions
A well-drafted cross-purchase agreement must define triggering events with precision. Death is common, but do not overlook disability, bankruptcy, termination for cause, voluntary resignation, divorce, loss of professional licensure, or deadlock in governance. Each event requires separate mechanics for notice, valuation, timing, and funding. When an insurance trust is the owner, the drafting must ensure that the trustee understands when a purchase is mandatory and how to apply proceeds to complete it.
Mandatory purchase provisions reduce the risk of post-event disputes. However, they must be matched with realistic timelines that account for claims periods under the policy, estate administration requirements, and regulatory approvals for professional practices. The trust should include authority for interim distributions and escrow arrangements so that the trustee can navigate delays in receiving the death benefit without breaching the agreement or fiduciary duties.
Complexity increases when the business operates in multiple jurisdictions or is subject to professional entity restrictions. The agreement should include contingency language authorizing a permitted transferee trust or a nominee structure if ownership restrictions apply, and the trust should authorize the trustee to hold interests indirectly if required by professional corporation or limited liability company statutes.
Valuation Mechanics: Avoiding Tax and Litigation Pitfalls
Valuation is often the most contentious component of a buy-sell. The agreement should describe a clear valuation method, such as a formula-based approach, an agreed-upon appraisal process with independent valuators, or a hybrid method keyed to GAAP financials with specific adjustments. The method must be synchronized with the trust’s purchase authority and with estate tax objectives to avoid Internal Revenue Code Section 2703 issues that could disregard the buy-sell price for estate tax purposes.
Laypeople frequently believe that a single number in an agreement will control for all purposes. In reality, if the valuation method is not commercially reasonable, regularly updated, and binding under state law, the IRS may dispute it, particularly when the buy-sell price deviates significantly from fair market value. Incorporate periodic updates, specify data sources, and establish tie-breaker procedures if appraisers disagree. The trust should be required to accept the agreement’s valuation outcome, and the trustee should be indemnified when relying in good faith on that process.
Consider basis consequences. In a cross-purchase, surviving owners typically receive increased basis in the acquired interests, which can deliver meaningful income tax benefits upon a later sale. The trust’s participation must be structured so that basis adjustments are realized by the appropriate parties, and the agreement should require the exchange of tax information post-closing to properly record basis and allocate purchase price among tangible and intangible assets where appropriate.
Transfer-for-Value and Policy Acquisition Rules
When policies are owned by a trust rather than by individual owners, the transfer-for-value rule becomes a significant concern. Transfers of life insurance policies for valuable consideration can cause a portion of the death benefit to become taxable as ordinary income. Common pitfalls include moving policies between owners without observing exceptions, failing to structure the trust as a partner or member of a partnership for purposes of the partnership exception, or inadvertently triggering a transfer when restructuring coverage during ownership changes.
Draft your documents with strict prohibitions on policy transfers absent a written opinion from counsel and CPA confirmation. If a transfer is unavoidable, ensure that an exception applies, such as transfers to the insured, to a partner of the insured, or to a partnership or LLC in which the insured is a partner or member. The trust’s status and the business entity’s tax classification must be aligned to fit within these exceptions. Seemingly minor changes in entity classification or ownership percentages can inadvertently break an exception and create substantial tax exposure.
In addition, confirm that ownership and beneficiary designations avoid constructive ownership issues that could undermine the desired tax outcome. The trust instrument should authorize policy exchanges under Section 1035, if appropriate, while cautioning that exchanges must not trigger transfer-for-value problems. These are not mere formalities; they are essential safeguards against unexpected ordinary income taxation of death proceeds.
Coordination with S Corporations, Partnerships, and LLCs
Entity type affects both drafting and tax consequences. For S corporations, cross-purchase agreements generally avoid the accumulated adjustments account and shareholder basis distortions introduced by entity redemption structures. However, trusts participating as purchasers must be eligible S corporation shareholders or use permitted structures, such as electing small business trusts, where necessary. Failure to observe these eligibility rules can terminate S status with severe tax consequences.
Partnerships and multi-member LLCs offer flexibility, but the presence of a trust purchaser requires careful drafting of the operating agreement. Capital accounts, Section 754 elections, and special allocations must be coordinated with the cross-purchase to ensure that basis increases and income allocations follow economic arrangements. Boilerplate documents are unlikely to suffice. The buy-sell, the ILIT, and the operating agreement should be cross-referenced and revised concurrently to reflect the intended tax results.
Professional practices and licensed entities impose additional restrictions on ownership, transfer, and voting. The cross-purchase agreement should anticipate these restrictions by permitting alternative structures, including voting trusts or permitted designees. The ILIT should authorize the trustee to hold nonvoting economic interests, and the agreement should provide for rapid reconfiguration if regulatory approvals are required post-closing.
Liquidity Solutions, Shortfalls, and Interim Funding
Insurance proceeds do not always align perfectly with the buy-sell price, particularly when valuations rise faster than coverage or when policy loans reduce net proceeds. The agreement should address shortfalls through mechanisms such as promissory notes, earn-outs, secured obligations, or escrowed installments. The trust should be empowered to accept installment notes or security interests and to enforce them without violating fiduciary duties.
Draft fallback provisions for policy disputes or delayed payment of claims. If the carrier contests the claim, the agreement should allow for bridge financing, interim distributions, and closing adjustments. The trustee’s authority to borrow, pledge assets, or participate in short-term financing arrangements is essential in these cases, and the trust should include exculpation provisions for good-faith actions taken to maintain business continuity and consummate the purchase.
In addition, the agreement should require periodic coverage reviews to recalibrate face amounts to business value. Tie these reviews to valuation updates and significant events such as acquisitions, major contracts, or debt issuances. The trust should include a mechanism for the trustee to request additional contributions or premium adjustments and a process to address refusals, including the potential termination or renegotiation of coverage.
Trustee Powers, Fiduciary Standards, and Administrative Provisions
The trustee’s powers must be robust and tailored to closely held business interests. Grant the trustee explicit authority to purchase, hold, vote, and sell business interests; to enter shareholder or operating agreements; to consent to amendments; and to participate in recapitalizations, mergers, or liquidity events. Provide investment flexibility under the prudent investor standard while acknowledging the unique risks of concentrated business holdings.
Define fiduciary standards and potential conflicts. The trustee may also be a purchasing owner or an officer of the company, which can trigger conflicts of interest. Include consent procedures, independent review mechanisms, or the appointment of a distribution or special trustee for conflict matters. This is not mere belt-and-suspenders drafting; it is a practical necessity to prevent later claims of self-dealing.
Administrative provisions should cover tax reporting, allocation of expenses, and indemnification. The trust should specify whether it is a grantor trust for income tax purposes, who pays income tax associated with trust income, and how trustee fees are determined. These details reduce uncertainty and prevent disputes among beneficiaries and purchasing owners when a triggering event occurs.
Marital Rights, Community Property, and Creditor Protection Considerations
Marital rights can complicate insurance and business ownership. In community property states, premiums paid with community funds may create community interests in the policy or the business, even when titled to a trust. Obtain spousal consents for the buy-sell agreement, trust establishment, and policy ownership. Include representations and warranties in the agreement confirming that all required consents have been obtained and that no spouse claims rights inconsistent with the arrangement.
Creditor protection is another key benefit of ILIT ownership, but it is not automatic. State law governs the extent of protection afforded to insurance proceeds and trust assets. The trust should include spendthrift provisions and avoid retained powers that could enable creditors to reach trust assets. Coordinate with state insurance exemptions and ensure that premiums are paid in a manner consistent with applicable fraudulent transfer laws, particularly when business risks are elevated.
Failure to address these nuances can lead to claims by spouses or creditors at death, delaying the purchase and threatening business continuity. Proper consents, waivers, and protective provisions in both the agreement and the trust materially reduce these risks.
Closing Mechanics After a Triggering Event
When a triggering event occurs, the parties must execute a clear closing sequence. The agreement should require prompt notice, appointment of an independent appraiser if needed, calculation and delivery of the purchase price, and simultaneous transfer of ownership interests against payment. The trust should designate the trustee as the authorized signatory for the purchasing owners’ side (if applicable) and set forth the process for receiving and applying insurance proceeds to the purchase price.
Document routing and timing matter. Require delivery of governing documents, cap tables, lien searches, tax certificates, and representations from the seller regarding liabilities and indemnities. The agreement should provide escrow instructions in case of disputes or unresolved contingencies. The trust should address how any remaining proceeds are handled after the purchase, including retention as reserves, reinvestment, or distribution under the trust’s dispositive provisions.
Post-closing matters should include amendments to company records, updated ownership ledgers, IRS elections as appropriate, and basis tracking. The agreement should obligate the parties to cooperate in post-closing tax reporting, including allocation of purchase price and elections that enhance basis and preserve tax objectives.
Common Drafting Mistakes That Undermine Cross-Purchase and Trust Objectives
Several recurring mistakes appear in do-it-yourself or template-based documents. These include misaligned ownership and beneficiary designations; failure to implement or document Crummey notices; inadequate valuation provisions that are either stale or inconsistent with estate tax requirements; and omission of mandatory purchase language tied to insurance proceeds. Each of these errors can disrupt the transaction and generate unintended taxes or litigation.
Another frequent oversight is ignoring transfer-for-value risk when policies are restructured. Seemingly innocuous changes, like reassigning a policy to a newly formed trust or admitting a new partner without coordinating policy ownership exceptions, can cause otherwise tax-free death proceeds to become taxable. Additionally, failure to confirm S corporation eligibility for trust purchasers or to coordinate with LLC operating agreements can trigger entity-level crises at the worst possible time.
Finally, many documents fail to anticipate liquidity shortfalls, regulatory approvals, or multi-jurisdictional constraints. Incorporate contingency plans, borrowing authority, and escrow mechanics, and ensure that trustee powers are sufficiently broad. Engage an experienced attorney and CPA to review the full structure before any policy is issued or transferred.
Implementation Roadmap: From Planning to Policy Issuance
A disciplined implementation process mitigates risk. Begin with a holistic planning session among the owners, counsel, and tax advisors to confirm objectives, entity constraints, and valuation methodology. Draft the cross-purchase agreement and the trust instrument concurrently, embedding cross-references and ensuring that the trustee’s powers match the buy-sell’s obligations. Obtain spousal consents and update governing corporate documents to recognize and enforce transfer restrictions and the buy-sell framework.
Next, underwrite and place the policies with clear ownership and beneficiary designations consistent with the trust and agreement. Establish the premium funding method, prepare Crummey procedures if gifts are expected, and set a calendar for annual notices and valuations. Create a compliance binder that includes executed documents, policy statements, premium schedules, Crummey notice templates, and a valuation protocol with update triggers.
Finally, conduct a closing rehearsal: verify that all parties understand notice procedures upon a triggering event, confirm trustee authority, test document integration, and review insurance carrier claim requirements. This level of preparation may feel redundant, but it is the difference between a smooth buyout and a contentious, tax-inefficient scramble.
Ongoing Maintenance: Reviews, Updates, and Governance
Once implemented, the structure requires regular maintenance. Review the buy-sell agreement and trust at least annually, and more frequently after major business events. Reassess insurance coverage based on updated valuations, debt levels, and strategic plans. Adjust premium funding strategies and revisit Crummey beneficiaries and withdrawal powers as family circumstances evolve.
Corporate governance should incorporate the buy-sell as a living document, not a static afterthought. Educate new owners and trustees on roles and responsibilities, and obtain updated consents and acknowledgments. Track S corporation eligibility if applicable, monitor LLC and partnership agreements for changes, and adopt Section 754 elections when purchases occur to align tax basis with economic reality.
Meticulous recordkeeping is essential. Maintain minutes noting annual reviews, valuation updates, policy changes, and trustee determinations. This paper trail substantiates tax positions, demonstrates fiduciary prudence, and reduces the likelihood of disputes among owners, beneficiaries, and taxing authorities.
Why Experienced Counsel and a CPA Are Indispensable
Even “simple” buy-sell arrangements are laden with technical traps that are not apparent at first glance. The intersection of insurance law, trust law, corporate governance, and federal and state tax rules creates a web of requirements that must be satisfied simultaneously. A misstep in any one area—be it a flawed valuation method, a botched Crummey process, or an ill-advised policy transfer—can render the arrangement ineffective or dangerously tax-inefficient.
An experienced attorney and CPA can identify and address issues before they mature into costly problems. They can tailor the trust instrument to the business entity’s characteristics, draft valuation provisions that satisfy commercial reasonableness and estate tax standards, and implement premium funding structures that align with gift and income tax objectives. They can also coordinate with insurance professionals to ensure that policy features and riders match the legal and tax requirements of the cross-purchase.
The implication is clear: drafting and implementing a cross-purchase agreement with an insurance trust as owner is not a do-it-yourself project. Engage qualified advisors, invest in precise documentation, and commit to ongoing maintenance. The result is a robust, tax-efficient structure that protects owners, beneficiaries, and the business itself.
