In a cross purchase situation, the shareholders (not the corporation) own the policies on each other. When a shareholder dies, the proceeds go to the beneficiary, i.e. the survivor. The survivor uses the proceeds to buy back the stock of the deceased.
Again assume the corporation is worth $2 million but now Bob and Joe each have a $1 million life insurance policy on each other. Joe dies. The $1 million life insurance proceeds go to Bob who pays the $1 million to Joe’s estate. Bob now owns 1,000 shares of stock and 100% of the agency.
In both of the above situations Bob ends up owning 100% of the agency. So what’s the big deal?
A few years go by and Bob sells the agency for $3 million. Only $2 million of the $3 million is taxable. Since Bob paid $1 million for the stock the IRS deems that he has $1 million in basis. (Basis is what someone pays for an asset less any depreciation expense, or amortization in the case of an intangible asset, that has been claimed on his/her tax return).
By structuring the deal as a cross purchase rather than a stock redemption, the surviving shareholder enjoys significant tax savings. In the stock redemption situation, Bob has no basis since he didn’t pay for Joe’s stock.
Number of Policies
If there are only two shareholders you only need two policies. But what if you have more than two shareholders? If you have three shareholders you need six policies. Four shareholders need 12 policies. The formula to determine number of policies needed is:
Number of policies needed = X times (X – 1)
where X equals the number of shareholders.
If you have six shareholders you need 30 policies, or do you?
Once you go beyond three shareholders you should consider setting up a separate trust that does nothing but hold the policies and distribute the proceeds on behalf of the members of the trust, (which are the shareholders). That way if you have 12 shareholders you only need 12 policies. Not only do you need fewer policies, it’s easier to manage.
What do you do if you currently have a stock redemption situation and existing policies? If the policies are term policies, the answer is simple. Change your agreement to a cross purchase agreement and change the owners and beneficiaries of the policies.
If the existing policies are not term policies and they have significant cash surrender value, you have a problem. If the policies are transferred from the corporation to the individual shareholders, the cash surrender value becomes taxable income to the new policy owner. If want to switch to a cross purchase arrangement in this situation it is usually best to get new term policies issued, assuming everyone is insurable at a reasonable cost.
How Much Insurance?
Most insurance agents say you should purchase as much life insurance as you can comfortably afford. But how much is enough?
Go back to your Shareholders Agreement. Does it address the value of the agency? If it states a formula, you know the “value” of the agency. If the Shareholders’ Agreement doesn’t state the value of the agency, you should get the agency valued by a qualified professional to determine the fair market value of the agency.
In either case, the value of the agency will fluctuate over time. Therefore, buy more than enough insurance to cover the current value as well as any reasonably expected increase in agency value.
Who Pays the Premium?
Ideally, the shareholders should pay the premiums personally. The funds can come from them personally or the agency may issue a bonus / dividends / etc. to give the shareholders the funds to pay the premium. Another option is to have the agency pay the premium in a cross purchase situation. In either event, the policy premium needs to be included on the beneficiary’s W-2 and documented properly.
Whether it’s a cross purchase or stock redemption agreement, under no circumstances should the premium payments be taken as a tax deduction. Doing so will result in the proceeds being taxable to the beneficiary.