Three siblings each own a third of a $5 million business. The oldest dies. Without a buy-sell agreement, the deceased sibling's spouse (who has never worked there) now owns a one-third interest and a vote in every decision.
A buy-sell agreement is a binding contract that establishes who buys a departing owner's interest, under what triggering event, at what price, and with what funding. Without one, state default law governs, rarely the outcome anyone would choose.
HIGH-FREQUENCY: The cross-purchase versus entity-purchase distinction appears in nearly every business succession question. Know the policy count, the premium payer, and (most critically) the basis treatment.
Cross-purchase agreements require each owner to personally buy the departing owner's interest. Each owner must be able to buy out any other owner, so every owner holds a policy on every other owner. The formula for total policies is n(n-1). Three owners need 6 policies. Four need 12. Five need 20. It scales poorly.
The advantage is the cost-basis step-up. When a surviving owner uses insurance proceeds to buy the deceased's shares at fair market value, that purchase price becomes the survivor's new basis.
Common mistakes
- Confusing basis treatment. Candidates remember n(n-1) versus n for policy count but forget the tax consequence. Cross-purchase gives a basis step-up. Entity-purchase does not. When the question asks about the "primary disadvantage" of entity-purchase for surviving owners, the answer is no basis step-up, not too many policies (that is the cross-purchase disadvantage).
- Section 1042 for S corporations. The gain deferral is available only for C corporation stock. S corp owners cannot use Section 1042. This distinction is tested directly.
- TRAP: An answer recommending Section 1042 for an S corp owner is always wrong.
Bottom line
- Cross-purchase agreements give surviving owners a cost-basis step-up but require n(n-1) policies (five owners need 5(5-1) = 20).
- Entity-purchase agreements need only n policies but provide no basis step-up.
- ESOPs allow Section 1042 capital gains deferral: C corporation stock only, 30% ESOP ownership minimum, with a qualified replacement property purchase within 12 months.
- Intentionally defective grantor trusts: grantor-trust rules let the seller ignore the sale for income tax while removing business value from the estate.
Exam shortcut
Policy count / basis question → cross-purchase uses n(n-1), entity uses n; basis step-up belongs to cross-purchase. Owner selling and deferring capital gains → ESOP with Section 1042, but verify C corp. "Estate rich, cash poor" with estate taxes due → Section 303, check the 35% threshold. Multi-generational transfer with active and inactive children → separate voting from economic value.
The full lesson (about 2,217 words, 15 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- F.53
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