Cross-Purchase vs. Entity Redemption: Buy-Sell Basics in Plain English

When a business owner dies, somebody has to buy their share.

There are really only two choices: the other owners buy it, or the company buys it.

That's the whole difference between a cross-purchase buy-sell and an entity redemption buy-sell. The names sound like something from a law school exam. The idea isn't.

I'm Harvey Baker Jr., a licensed Texas agent in McKinney. Here's how each one works, in plain English, and what to ask your attorney and CPA before you pick.

Quick refresher: what a buy-sell does

A buy-sell agreement is a written contract between owners. It says what happens to an owner's share when something like death, disability, retirement, or divorce happens: who buys it, how the price is set, and how it gets paid.

Life insurance is a common way to fund the death part, so the money is there when it's needed. How the policies are owned depends on which type of agreement you have. That's where these two setups come in.

Cross-purchase: the owners buy it

In a cross-purchase setup:

• Each owner owns a policy on each of the other owners.

• Each owner pays the premiums on the policies they own.

• If an owner dies, the surviving owners receive the death benefit.

• The survivors use that money to buy the deceased owner's share from the family or estate.

The company itself isn't the buyer. The individual owners are.

Entity redemption: the company buys it

In an entity redemption setup (sometimes called a stock redemption):

• The business owns a policy on each owner.

• The business pays the premiums.

• If an owner dies, the business receives the death benefit.

• The business uses that money to buy back the deceased owner's share from the family or estate.

The surviving owners end up owning a bigger percentage of the company because there are fewer shares outstanding, not because they bought anything themselves.

The policy math changes fast

Here's a simple, practical difference. With two owners, either setup takes two policies. Add owners and a basic cross-purchase grows quickly, because every owner needs a policy on every other owner:

• 2 owners: 2 policies either way

• 3 owners: 6 policies in a basic cross-purchase, 3 in an entity redemption

• 4 owners: 12 vs. 4

• 5 owners: 20 vs. 5

More policies means more paperwork, more premiums to track, and more chances for something to slip. There are ways to simplify a cross-purchase with more owners, like having a trust or a separate entity hold the policies. Those setups have their own rules, so your attorney should design them.

Who pays, and is that fair?

In a cross-purchase, each owner pays for coverage on the others. If one partner is older or has health issues, coverage on that partner may cost more, and the younger partner is often the one paying for it. Some partners are fine with that. Some adjust compensation to even it out. It's worth talking about up front.

In an entity redemption, the business pays all the premiums, so the cost is shared in proportion to ownership, in a sense. That can feel simpler, but it also means company money is tied up in the policies.

Coverage, eligibility, and rates vary by carrier and health.

The tax and legal questions to raise

I don't give tax or legal advice, and this is an area where the details really matter. Here are questions worth taking to your CPA and attorney:

• Cost basis. Advisors often point out that the two setups can leave surviving owners with a different tax basis in their shares, which may matter if they sell later. Ask how this applies to you.

• The 2024 Supreme Court decision. In Connelly v. United States (2024), the Supreme Court ruled that, in that case, life insurance proceeds a company received to fund a redemption counted toward the company's value for federal estate tax purposes. Many attorneys and CPAs have been revisiting entity redemption setups since. Ask whether it affects yours.

• Changing structures later. Moving existing policies from one setup to another can raise tax issues, sometimes called transfer-for-value rules. Get advice before anyone transfers a policy.

• Your entity type. C corporations, S corporations, and LLCs can be treated differently. What works for one may not work for another.

• Creditor exposure. Policies or cash held by the business may be exposed to business creditors in ways personally owned policies aren't. Ask your attorney.

Consult your tax or legal professional for advice specific to your situation.

There are hybrids, too

Not every agreement is purely one or the other. Some agreements give the company the first option to buy and the owners the next option, and decide at the time of the event which path to take. These are sometimes called "wait and see" setups. They can add flexibility, and they can add complexity. Your attorney can tell you whether it makes sense for your business.

Hypothetical example for illustration only: Picture three partners who own an engineering firm in Plano. They signed an entity redemption agreement years ago, but two of them later bought personal policies on each other "for the buy-sell." Now the agreement says the company buys, the policies pay the partners, and the third partner isn't covered at all. Nobody did anything wrong on purpose. The paper and the policies just drifted apart. The fix starts with putting the agreement and the policy list side by side.

Questions to ask before you choose

• How many owners do we have now, and do we expect more?

• Are our ages and health similar, or very different?

• Who should pay the premiums, and does that feel fair to everyone?

• What does our CPA say about basis, entity type, and estate tax?

• What does our attorney say about the 2024 decision and creditor exposure?

• Does our current policy ownership actually match our current agreement?

The match test

If you already have a buy-sell, here's the quickest check you can do this week:

Pull the agreement. Pull the policies. Do they match?

Who owns each policy, who pays, and who gets the money should line up with what the agreement says. If they don't, it's a hope with a handshake. Better to find out now than on the worst Monday of your partner's family's life.

Get your Gap Map (free, 20 minutes)

The Gap Map is a one-page look at where your home, your business, and your exit still depend on one person. Three columns. Plain English. You keep it either way, whether you buy anything or not.

Call or text 430-373-7752 with the word MAP for a free one-page Gap Map. Or learn more at bakerlegacypartners.com.

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Insurance products involve costs, limitations, exclusions, and suitability considerations. This article is educational and is not tax, legal, or financial advice.

Harvey Baker Jr., Licensed Texas Life, Accident & Health Agent, TX License #3470534. Coverage, eligibility, and rates vary by carrier and health.