The economical and efficient method of a cross purchase buy-sell plan that is funded with life insurance allows a deceased partner’s business interest to be quickly bought by the remaining partners without the having to borrow money, drain business assets, or become involved in a long drawn-out legal battle.
When involved in a partnership, if one of the partners dies, then the partnership no longer exists. This can be problematic for the remaining partners or the heirs of the partner who has died. However, with life insurance in place under a cross purchase buy-sell plan, both partner’s and their families can be protected.
How a Cross Purchase Buy-Sell Plan Works
Beginning with the partners (Partner A and Partner B), a cross purchase buy-sell agreement is entered into with the understanding that a deceased partner’s interest and the executor of the deceased partner’s estate is directed to sell the interest to the surviving partner for an agreed-upon price.
This does not prohibit one partner from dissolving the partnership at any time, but rather commits each partner into selling their portion of the business in the event of their death.
Next, each partner purchases a nondeductible life insurance that will cover the other partner in the amount of the cost of purchasing the interest of that partner, naming the other partner as insured and the purchasing partner as owner and beneficiary. The total of both policies is the cross purchase buy-sell agreement.
Therefore, each partner owns, is the beneficiary of, and pays the nondeductible premiums for the life insurance on the other partner. The amount of the life insurance is approximately the purchase price of the partner’s share.
How a Cross Purchase Buy-Sell Plan Works Upon the Death of One Partner
When one partner dies, the surviving partner immediately receives an income tax-free death benefit from the deceased partner’s life insurance policy. Then, the surviving partner uses this income tax-free money to buy the partnership interest from the deceased partner’s estate for the purchase price agreed-upon in the buy-sell agreement. Once the estate is settled, the executor disperses the balance of the estate to the deceased partner’s heirs.
Other Features of an Insured Cross Purchase Buy-Sell Plan
There are several features, besides serving as a source of funding, that an insured cross purchase buy-sell plan provides.
- Prompt and Certain Payment – Unlike probate process that are subject to the time and expense of probate, life insurance proceeds are available immediately to finish the purchase of the deceased partner’s interest.
- Creating Cash – The same event that creates the immediate need for cash also creates the source of cash to purchase the deceased partner’s interest. In the uncertain time of a partner’s death, life insurance provides the cash for the certain needs created by the partner’s death.
- Income Tax-Free – If the death benefit is more than the total premiums paid, this perceived gain is generally received free of income tax.
- Financing Problems Avoided – With life insurance, the problems that are seen with other financing methods are eliminated. These problems include a drain in cash on the business, a strain on the budget with monthly payments, or legal issues with the heirs of the deceased partner’s estate.
Insured Cross Purchase Buy-Sell Plan Tax Results
The tax results from an insured cross purchase buy-sell-plan are numerous:
- Tax deductions for premium payments on life insurance to fund an insured cross purchase buy-sell plan are not allowed.
- The proceeds received from the life insurance of a partner’s death by the surviving partners are not subject to federal income tax.
- In dealing with capital gains tax, the transfer of the deceased partner’s interest in exchange for the money received from the life insurance policy is not subject to federal income tax if the purchase price of the business interest equals the fair market value of the business at the time of the deceased partner’s death.
- The surviving partner’s tax basis increases by the amount of the purchase price.
- Death proceeds from an insured cross purchase buy-sell plan are not included in the deceased partner’s estate unless the deceased partner is listed as the owner of the policy on his or her life.
- The value of the partnership interest is set for federal estate tax purposes if the purchase price established in the buy-sell agreement represents a realistic value of the deceased partner’s interest. The agreement must prohibit the partners from disposing of their partnership interest during their lifetime without offering it to the other partners for the same price.
Insured Cross Purchase Buy-Sell Plan Checklist
If partners are interested in creating an insured cross purchase buy-sell plan, several items should be completed now, in the short-term, and in the long-term.
The value of the proprietorship should be established now. The appropriate life insurance funding vehicles should also be selected immediately. Each partner’s insurability should be established and arrangements for paying premiums should be discussed.
In the short-terms, a cross purchase buy-sell agreement should be drafted and executed, the issued policy should be reviewed, and funding options for the purchase of partnership interests for both partner’s retirement or disability should also be evaluated.
Finally, in the long-term, the plan and its funding should be reviewed annually to ensure that the plan remains current. The purchase of key employee indemnification insurance on the partners should also be considered.
With the complexity of an insured cross purchase buy-sell agreement, a financial expert should be consulted. However, with proper planning and diligent execution, creating stability and a smooth transition at the death of a partner in a partnership can be obtained leaving family, friends, and partners the ability to deal with other matters.