California Injury Attorney Blog

Buy-sell agreements usually take the form of either a redemption,in which the corporation purchases its own shares from the selling shareholder, or a cross-purchase, in which the other shareholders purchase the seller's interest. In the past, corporate purchases havegenerally been preferred to cross-purchases because of their simplicity
and because corporate rather than personal funds or credit are used to complete the purchase. See 1 Ballantine & Sterling, CaliforniaCorporation Laws §63.03 (4th ed); Weary, Preserving CorporateStructure (Buy-Sell Agreements, Preferred Stock Recapitalizations,Spin-Of{, Life Insurance, Extension of Time to Pay Federal Estate
Tax), NYU 39th Inst Fed Tax §1O.03[2] (1981). However, cross-purchases are becoming more popular because of the potential adverse tax consequences of redemptions, particularly when insurance funding is used agreement can also benefit the remaining shareholders because they receive a basis in the purchased shares equal to their purchase price, which can be especially useful to an S corporation if there are losses
that can be passed through to the shareholders. IRC §1012.
With an entity purchase, the basis of the shares of the remaining shareholders is not affected, even though the value of those shares may be increased by the redemption. See IRC §1060(a).

A cross-purchase permits the relative power between groups of shareholders to remain the same by allowing them to structure the buyout so that the departing shareholder's interest is purchased by members of the same group. See 1 Ballantine & Sterling, Corporation Laws §63.03[3][a]. Finally, when insurance funding is used, a cross purchase is more equitable than a redemption when there are differences in the ages or shareholdings of the owners.

For most shareholders, the primary drawback of a cross-purchase is that they must use their own funds to finance the buyout. If the shareholders have to withdraw dividend income from the corporation to fund the buyout, the funds will be subject to double taxation:once as income to the corporation and again when they are received
by the shareholders.

Another disadvantage of cross-purchase agreements is their increased complexity when insurance funding is used. In addition to the additional policies required, the shareholdersmust be able to monitor the policies to make sure that none are allowed to lapse. Insurance proceeds may also be subject to taxation under the transfer-for-value rule. IRC §101(a);
Selecting the appropriate form for the buyout requires consideration of complex legal and tax factors in addition to the individual circumstances and goals of the parties to the agreement.

Depending on the form of agreement may permit the parties to delay the decision until the triggering event occurs, when the financial and tax situations of the parties can be better evaluated.