04 Aug Cross-Purchase vs. Redemption: The Buy-Sell Choice That Costs You at Tax Time
Two business owners each own 50% of a company. One of them dies. The survivor buys out the estate and now owns 100%. Same company. Same buyout price. Same insurance payout. But depending on how the buy-sell agreement was structured, one of those survivors could owe significantly more in tax when the business is eventually sold.
The difference comes down to two types words: cross-purchase or redemption. Most business owners pick one without fully understanding the tax consequences. By the time the consequences arrive, it’s too late to restructure.
How a Cross-Purchase Works
In a cross-purchase, each partner buys insurance on the other partner’s life. When your partner dies, you personally collect the death benefit. You use that money to buy your partner’s shares from their estate. You now own 100%.
The tax advantage is this: when you purchase those shares, you get a new cost basis equal to what you paid for them. If you paid $3 million for your partner’s 50%, your basis in those shares is $3 million. When you eventually sell the whole company, your taxable gain on that half is measured from $3 million, not from zero.
This stepped-up basis can save the surviving owner a substantial amount in capital gains tax down the road.
How an Entity Redemption Works
In an entity redemption (sometimes called a stock redemption), the company buys insurance on each partner’s life. When your partner dies, the company collects the death benefit. The company uses that money to redeem (buy back) the deceased partner’s shares. The shares are retired. Your percentage increases to 100% automatically.
The problem? You didn’t buy anything. The company redeemed shares. Your original basis in your own shares stays the same. If your original cost basis was $50,000, it’s still $50,000 after the redemption. When you sell the company years later, your taxable gain is the sale price minus $50,000. That’s a much larger tax bill than the cross-purchase survivor faces.
The Tax Difference in Practice
Imagine the company eventually sells for $16 million. The cross-purchase survivor has a basis of $8 million in the acquired shares plus their original basis in their own shares. The redemption survivor’s basis is whatever they originally invested. The difference in capital gains tax between those two positions can be significant, often hundreds of thousands of dollars.
This is money the redemption survivor didn’t plan to lose. The buyout worked. The insurance paid out. The transition was smooth. The tax bill arrives years later, and by then nobody remembers that a different buy-sell structure would have prevented it.
When Each Structure Makes Sense
Cross-purchase works best with two owners. Two partners means two insurance policies. Clean, simple, and the surviving partner gets the stepped-up basis. For two-owner businesses, cross-purchase is usually the better choice from a tax perspective.
Redemption works better with three or more owners. In a cross-purchase arrangement with three owners, you need six policies. Four owners means twelve. The logistics become unmanageable. Entity redemption keeps it simple: the company owns one policy per partner. You give up the basis benefit, but you gain a structure you can actually administer. The policy structure mechanics are explained in detail here.
There are also hybrid structures that try to capture the tax benefit of cross-purchase with the administrative simplicity of redemption. These are more complex but worth exploring with your attorney and tax advisor if you have three or more partners and the tax stakes are high enough.
The Insurance Has to Match the Structure
The structure of the agreement dictates who owns the policies, who receives the death benefit, and where the money flows. If your buy-sell agreement says cross-purchase but the company owns the policies, the mechanics break down when someone dies. Life insurance is the most common funding mechanism for both structures. The agreement and the policies have to be coordinated or neither one works as intended.
The Structure Decision Is Hard to Undo
Restructuring a buy-sell agreement from redemption to cross-purchase (or the reverse) is possible, but it is not simple. It involves transferring policy ownership, potentially triggering transfer-for-value rules that can make the death benefit taxable, and rewriting the agreement itself. It is far easier and cheaper to get the structure right the first time than to fix it after the policies are in place.
If you have a buy-sell agreement and you are not sure whether it is structured as cross-purchase or redemption, find out. If you are not sure whether that structure is the right one for your situation, that is worth a conversation with your attorney and tax advisor before the next triggering event makes the question academic. The five triggering events every buy-sell agreement should address are covered here.
Related Reading
Buy-Sell Agreements. The full overview: the three structures, the five trigger events, and why every partnership needs one.
Buy-Sell Agreements and Life Insurance. How life insurance funds the buyout for both cross-purchase and redemption structures.
How to Arrange Insurance Funding of Your Buy-Sell Agreement. Matching your policy structure to your agreement structure so the money flows correctly.
Need a Partnership Agreement. The operating rules every partnership needs alongside its buy-sell agreement.
Is Your Buy-Sell Structure Costing You at Tax Time?
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