Structure of the Buy-Sell Agreement

Once succession planning establishes that buy-sell provisions will govern the transfer of a departing owner’s interest, one structural decision determines nearly everything that follows: whether the remaining owners buy the interest, the business buys it, or some combination of the two. This information is for the advisor who must guide that choice, and for the owner who will make the choice.

The advisor’s discipline is not to prefer one structure as a matter of habit. For a given business, each structure produces a materially different tax result, a different funding burden, and a different exposure to the claims of business creditors, and the correct choice depends on the entity’s tax status, the number of owners, and how the purchase will be funded.

A cross-purchase structure has the remaining owners acquire the departing owner’s interest directly, each buyer purchasing a share under an agreed formula. A cross-purchase gives the purchasing owners a cost basis in the interest they acquire, equal to what they paid for it. In a cross-purchase, the remaining owners are personally obligated to fund the purchase, which keeps the purchase price outside the reach of the business’ creditors but places the burden, and the risk that an owner lacks the resources to perform, on the individuals themselves.

A redemption structure has the business itself acquire the interest, retiring it rather than passing it to the remaining owners individually. A redemption gives the remaining owners no increase in cost basis, because the business, not the owners individually, is the buyer; the surviving owners’ basis in their own interests is unchanged. Where the business is later sold or makes future distributions, that difference in basis can produce a materially different tax result for the remaining owners, and it deserves explicit discussion with the owners before the structure is chosen, not discovery at the next sale.

For a departing owner, a redemption carries a tax risk a cross-purchase does not: unless the redemption satisfies the sale-or-exchange requirements of the Internal Revenue Code, the payment can be recharacterized as an ordinary-income dividend rather than a capital gain, taxed without regard to the owner’s basis in the interest. A cross-purchase, by contrast, is a straightforward sale between the parties and does not raise this risk. A redemption-based structure should be drafted and administered with this test in mind, not assumed to qualify automatically. ^[1]

In a redemption, the business is obligated to fund the purchase, which exposes the purchase price to business creditors and to state-law restrictions against distributions that would impair corporate capital.

A hybrid structure combines the two structures, commonly by having the business redeem the portion of the interest that qualifies for the most favorable tax treatment and requiring the remaining owners to cross-purchase the balance. This is one reason a hybrid structure is common in practice: it lets the plan capture the redemption’s administrative simplicity for routine funding while reserving cross-purchase treatment for the portion of the transaction where the tax result favors it.

Where the business is an S corporation, a redemption also reduces the corporation’s accumulated adjustments account, the mechanism by which the corporation’s already-taxed income can later be distributed to the remaining owners without a second tax. A cross-purchase does not touch this account. For an S corporation with multiple owners planning to remain in the business for years after an owner’s departure, this is often the more consequential difference, well beyond the immediate tax treatment of the departing owner’s payment. ^[2]

Where life insurance funds the purchase, the structure determines how many policies the plan requires. A cross-purchase among more than two owners requires a policy on each owner’s life owned by every other owner, a number that grows quickly as owners are added. A redemption avoids this, since the business holds a single policy on each owner’s life. This is a practical, not merely a tax, reason that closely held businesses with several owners often prefer a redemption or a hybrid structure once a third or fourth owner joins the business. ^[3]

The succession plan and the owner agreement’s buy-sell provisions should state the basis for the structure decision, and not leave it to be inferred from the language of the provisions. No one of these differences will determine the best decision. The advisor’s task is to lay each structure out against the specific business, its entity type, its number of owners, and its funding capacity, and to make the resulting choice deliberate and understood by all the owners.

^[1] See I.R.C. §302(b) (substantially disproportionate redemptions, redemptions not essentially equivalent to a dividend, and complete terminations of interest) and §303 (redemptions to pay death taxes and related expenses).

^[2] See I.R.C. §1368(c) (treatment of S corporation distributions with respect to the accumulated adjustments account).

^[3] The number of cross-purchase policies required among n owners, each insuring every other owner, is n(n−1).