Understanding the Core Structures: Cross-Purchase Versus Entity-Purchase
Buy-sell agreements are designed to govern the transfer of ownership interests upon death, disability, retirement, or departure of an owner. Two dominant structures are the cross-purchase arrangement and the entity-purchase (or redemption) arrangement. In a cross-purchase, the remaining owners agree to purchase the departing owner’s interest directly. In an entity-purchase, the business itself agrees to redeem the interest. These structures are deceptively similar in commercial effect, yet they diverge significantly in tax treatment, administrative complexity, and long-term planning outcomes.
Laypeople often assume the two are interchangeable or simply a matter of preference. In reality, they change who owns insurance policies, who receives basis benefits, and how proceeds and redemptions are taxed. Minor differences in drafting and funding can cause major tax consequences, particularly when multiple owners, disparate ownership percentages, S corporation status, or family ownership are involved. Selecting the wrong structure, or drafting the right structure poorly, can result in unexpected dividend treatment, lost basis step-up, inadvertent second-class-of-stock problems for S corporations, or even taxable death benefits due to the transfer-for-value rule.
Basis Consequences Drive Long-Term After-Tax Results
The income tax basis outcomes are among the most important differences. In a cross-purchase arrangement, the surviving or remaining owners acquire the interest directly and receive basis equal to the purchase price in the acquired shares or units. That basis increase is critical: it can materially reduce capital gain on a future sale of the business or, in pass-through entities, increase the owners’ basis for loss utilization and distribution planning. In contrast, an entity-purchase generally produces no step-up in basis for the other owners’ interests; the redeeming business may reduce its outstanding shares, but the remaining owners’ basis in their own shares remains unchanged.
The practical impact can be large. Consider an S corporation or partnership where the entity expects significant future income or a near-term sale event. A cross-purchase can align tax basis with economic investment, preventing double taxation through high gains at exit. By comparison, a redemption may appear administratively easier but leaves the survivors with “old” basis, potentially inflating taxable gain later. Despite this, basis modeling is frequently overlooked during initial drafting, particularly when insurance funding makes the liquidity feel “free.” A rigorous basis projection under multiple exit scenarios is indispensable before choosing a structure.
Life Insurance Funding: Transfer-for-Value and Policy Ownership Pitfalls
Life insurance commonly funds buy-sell obligations, but the tax rules around who owns and benefits from a policy are fraught with traps. Under the transfer-for-value rule, a life insurance death benefit can lose its income tax exclusion if the policy is transferred for valuable consideration, subject to limited exceptions. Cross-purchase agreements often proliferate policies—each owner insures the others—raising administrative burdens and presenting the risk that later ownership changes or policy consolidations inadvertently trigger transfer-for-value. Solutions such as using a properly structured insurance LLC or partnership can mitigate risk but must be planned carefully to fit within statutory exceptions.
Entity-purchase structures centralize ownership of policies in the company, simplifying administration. However, centralization can introduce other risks, including employer-owned life insurance compliance requirements and financial statement implications. Moreover, reorganizations, mergers, changes in ownership, or conversions between cross-purchase and redemption forms can accidentally create a disqualifying transfer. Clients often assume that “insurance is tax-free by default,” which is incorrect. A thorough review of policy ownership, beneficiary designations, funding mechanics, and any anticipated transfers is essential to preserve the exclusion and avoid a preventable tax surprise.
Redemption Treatment: Dividend Versus Sale or Exchange
In an entity-purchase, the tax character of the redemption proceeds paid to the departing owner is paramount. If the redemption fails to qualify under the sale-or-exchange rules (for example, a complete termination of interest or a substantially disproportionate redemption), the IRS may recharacterize the payment as a dividend. Dividend treatment can be far more expensive than capital gain treatment, especially if basis offsets are limited or if the corporation has earnings and profits. The intricacy lies in the thresholds for substantial disproportion and the family attribution rules that can treat an owner as still owning shares held by certain relatives or entities, thereby defeating qualifying status.
These nuances regularly catch families and closely held groups off guard. Waiving family attribution, where permitted, requires stringent compliance and post-redemption behavior, including prohibitions on certain reinvolvement. Failing to plan for these issues at the drafting stage is a common error, and “fixing it later” is rarely straightforward. Even simple redemptions can have different outcomes based solely on whether a relative owns a small minority interest, whether the departing owner sits on the board post-transaction, or whether there is a side agreement for consulting services. Sophisticated pre-transaction modeling and documentation are necessary to achieve desired capital gain treatment.
S Corporation Nuances: One Class of Stock, AAA, and Basis Alignment
S corporations introduce additional layers of complexity. The one class of stock rule prohibits arrangements that create disparate distribution or liquidation rights, yet poorly drafted buy-sell provisions can inadvertently create such disparities. Insurance funding in an entity-purchase can also affect the accumulated adjustments account (AAA) and distribution planning. Meanwhile, cross-purchase structures may better align individual shareholder basis with actual investment, which in turn influences the taxability of future distributions and the ability to absorb pass-through losses.
Complication increases when there are disproportionate ownership interests or varying ages and health among shareholders. Premium costs frequently differ, and if a corporation pays unequal premiums without careful structuring, the result can be disguised gifts or constructive distributions. Furthermore, the presence of historic C corporation earnings and profits, potential built-in gains tax exposure, and state-level S corporation rules can materially change the optimal design. These are not academic footnotes; they materially drive after-tax results and can undermine the S election if overlooked.
C Corporation and Employer-Owned Life Insurance Compliance
For C corporations, a redemption framework can feel administratively attractive, but corporate-level considerations cannot be ignored. Although corporate alternative minimum tax rules have evolved, life insurance proceeds and their treatment within a corporation still require disciplined accounting and tax reporting. The employer-owned life insurance regime imposes notice, consent, and reporting requirements to preserve income tax exclusion. Failure to meet these requirements can render otherwise excludable death benefits taxable. Senior executives may also face fringe benefit implications if the policy features are not carefully documented.
Clients often assume that because the company writes the checks, the company should simply own the policies. That assumption is risky. In addition to compliance with employer-owned life insurance rules, there are interactions with redemption taxation, earnings and profits, financial covenants, and state insurance law constraints. On balance, a cross-purchase approach can sometimes provide a cleaner tax outcome for owners, while a redemption may offer operational simplicity. The correct answer depends on detailed facts: entity type, policy sizes, lending relationships, and exit horizon should all be evaluated before finalizing the structure.
Valuation, Section 2703, and Estate Tax Liquidity Planning
Owners frequently expect a buy-sell agreement to control the value of the business for estate tax purposes. That belief is only partially correct. Under valuation rules, including those that address restrictions and buy-sell arrangements, an agreement will affect estate tax valuation only if it meets stringent criteria: it must be a bona fide business arrangement, not a device to transfer property to family members for less than full and adequate consideration, and it must reflect terms comparable to similar arrangements negotiated at arm’s length. A casually drafted or static price formula can be disregarded, resulting in materially higher estate tax values than expected.
Liquidity planning is equally nuanced. Section 303 redemptions can permit a corporation to redeem shares to cover death taxes and funeral expenses with sale-or-exchange treatment, but the thresholds and timing are exacting. Coordination between the buy-sell agreement, insurance funding, and the decedent’s estate plan is essential to avoid missed opportunities. Uncoordinated documents can create conflicts between estate fiduciaries and the company, cause double counting of liquidity needs, or result in tax characterization inconsistent with the plan’s goals. Periodic valuations, formula pricing tied to credible metrics, and cohesive estate planning are indispensable.
Premium Inequities, Constructive Gifts, and Split-Dollar Strategies
When owners are different ages or have differing health profiles, insurance premiums may vary widely. If a business pays unequal premiums in a way that benefits one owner more than another, there may be constructive dividends or constructive gifts. In cross-purchase structures, it is common for owners to pay premiums personally; however, side arrangements to “even out” costs can accidentally create reportable gifts or imputed income. Documentation must be precise about who bears premiums, who owns policies, and the economic expectations among owners.
Split-dollar life insurance can help manage premium burdens, but it brings its own tax regimes: the economic benefit regime and the loan regime. Each imposes different reporting, valuation of benefits, and interest or inclusion calculations. Misapplication can forfeit the expected tax advantages or trigger unexpected ordinary income. It is unwise to implement split-dollar within a buy-sell context without modeling the interaction of premium flows, exit scenarios, and policy ownership over long horizons. Even routine annual renewals require careful attention to avoid drift from the intended tax posture.
Disability, Retirement, and Installment Buyouts: Ordinary Income, Interest, and Imputed Rules
Buy-sell agreements are not only about death. Disability and retirement triggers are common, and the associated payments are not necessarily capital gain. For service partners in particular, unrealized receivables and hot assets can generate ordinary income upon buyout. When buyouts are paid over time, interest accrues under applicable federal rates, and imputed interest rules can recharacterize a portion of payments. Simple payment schedules drafted to “match cash flow” can inadvertently create adverse tax timing or character outcomes if they ignore statutory imputation and original issue discount rules.
Owners also underestimate the recordkeeping needed to support installment methods and basis recovery. For pass-through entities, the interplay of basis, §754 elections, and hot asset allocations complicates reporting. The agreement should specify allocation of purchase price among asset classes or partnership interest components and require cooperation on information reporting. Without that clarity, taxpayers may face disputes about character, timing, and reporting that are expensive to resolve years later when memories have faded and advisors have changed.
Community Property, Attribution, and Family Dynamics
In community property jurisdictions, ownership and basis are often misunderstood by business owners. A deceased owner’s spouse may hold an undivided community property interest, affecting voting, transfer provisions, and tax reporting. In entity-purchase redemptions, family attribution rules can prevent desired sale-or-exchange treatment if the departing owner is constructively treated as still owning shares held by relatives. Even in cross-purchase structures, spousal consents and properly drafted marital property acknowledgments are essential to avoid disputes and unanticipated tax consequences.
Family business transitions heighten the risk of attribution pitfalls and valuation disputes. A redemption that fails the substantial disproportion test due to a child’s minority interest can transform what was modeled as capital gain into dividend income. Waivers of family attribution exist but require strict adherence to post-redemption restrictions, often at odds with the family’s desire for ongoing involvement. These legal overlays are not intuitive and should be analyzed long before any triggering event occurs, particularly where estate plans anticipate gifts or sales to descendants.
Coordination with Debt, Covenants, and Lender Approvals
Many agreements assume that insurance proceeds will seamlessly fund the buyout. However, loan covenants and collateral arrangements may restrict policy assignments, cash value access, or distributions required to service debt. Lenders may require consent to redemptions or purchases, and they may impose mandatory prepayments upon receipt of insurance proceeds. If the agreement does not anticipate these restrictions, the parties may be forced into suboptimal tax paths, such as switching from an intended cross-purchase to a hurried redemption or vice versa, with unmodeled tax results.
Moreover, the tax cost of shifting from one structure to another on the eve of a triggering event can be severe. Policy transfers can invoke the transfer-for-value rule, while hastily arranged redemptions may fail sale-or-exchange tests. Agreements should therefore incorporate lender consent mechanics, contingency funding hierarchies, and tax-resilient fallback provisions. These are not boilerplate concerns; they are integral to preserving the carefully modeled tax outcomes when real-world banking constraints intervene.
Documentation, Governance, and Ongoing Maintenance
Even the best-designed structure can fail without disciplined maintenance. Annual reviews should confirm policy ownership and beneficiary designations, verify premium payer arrangements, update valuation formulas or appraisal protocols, and test S corporation compliance. Corporate minutes or manager resolutions should document the business purpose of the arrangement, any changes to ownership, and the alignment of the agreement with evolving capital structures. For partnerships and LLCs, tracking capital accounts, §704(b) allocations, and target capital mechanisms helps support the integrity of tax reporting when a buy-sell event occurs.
Owners frequently delegate these tasks informally and assume the insurance agent, accountant, or lawyer will “handle it.” In reality, each advisor controls only part of the picture, and disconnects are common. A coordinated calendar and responsibility matrix are essential, including who updates beneficiary designations, who orders valuations, and how amendments are approved and recorded. Misalignment among documents—operating agreement, shareholder agreement, insurance endorsements, and employment agreements—can create ambiguity that courts and the IRS will not resolve in the taxpayer’s favor.
Common Misconceptions That Increase Tax Risk
Several recurring misconceptions deserve emphasis. First, the belief that “insurance proceeds are always tax-free” overlooks transfer-for-value and employer-owned life insurance compliance. Second, the notion that “a redemption is the same as a purchase” ignores basis outcomes and dividend risk under redemption rules. Third, “a formula price in the agreement controls estate tax value” is only true if stringent requirements are met and the formula is maintained. Finally, “S corporations can use any buy-sell terms they like” fails to account for one-class-of-stock constraints and distribution parity.
These misconceptions persist because buy-sell agreements straddle corporate, partnership, insurance, estate, and income tax regimes. Each has its own definitions and exceptions that do not always align. The friction between these regimes is where taxpayers most often lose value—through dividends instead of capital gains, lost basis step-up, taxable insurance proceeds, or disallowed valuations. Recognizing these misunderstandings early is itself a planning technique, steering stakeholders toward rigorous modeling and professional oversight.
Choosing the Right Structure: A Practical, Tax-Centric Framework
There is no universally “best” structure; there is only a structure that best fits the owners’ objectives, entity type, financing realities, and anticipated exit paths. A practical framework begins with modeling after-tax outcomes across likely scenarios: death of each owner, disability, voluntary sale, and future third-party exit. For each scenario, compare basis effects, character of income, administrative burden, and compliance risks. The default preference for cross-purchase due to basis step-up may yield to a redemption if there are many owners, if insurance administration would be onerous, or if lender requirements dictate central control of policies.
Hybrid approaches can work, such as “wait-and-see” agreements that allow the company a first option to redeem and, if declined, permit cross-purchases. Yet hybrid structures amplify the need for clarity on policy ownership, transfer restrictions, and tax elections to avoid transfer-for-value and mischaracterization. The agreement should integrate with the owners’ personal estate plans, including power-of-attorney provisions, to ensure that decisions taken in a crisis align with the intended tax posture. Precision at the outset is far less costly than retrofitting tax fixes after a triggering event.
Why Professional Guidance Is Non-Negotiable
Buy-sell agreements are often drafted during entity formation or financing events, when speed and simplicity are prized. Unfortunately, these agreements govern the most tax-sensitive transactions an owner will ever undertake. The intersection of basis, redemption characterization, valuation rules, insurance tax regimes, and entity-specific constraints means that small drafting choices have years-long consequences. A template or off-the-shelf solution rarely addresses owner-specific facts such as disparate ages, existing E&P, family attribution exposure, or lender restrictions.
An experienced attorney-CPA team will not merely “paper the deal.” Instead, they will build a financial and tax model, vet assumptions with the insurance advisor, check S corporation eligibility, test redemption characterization, and align the agreement with estate planning documents. They will also design maintenance protocols so that the arrangement ages well. Owners who invest in this rigor at the outset typically save multiples of the advisory cost by avoiding dividend recharacterization, preserving tax-free insurance treatment, securing basis step-ups, and sustaining intended estate tax valuations. In short, professional guidance transforms a fragile plan into a resilient one.
