For closely held corporations and partnerships, a **Buy-Sell Agreement** funded by life insurance is the primary instrument for ensuring business continuity and liquidity upon the death of a shareholder. However, the structural choice between a **Stock Redemption (Entity Purchase)** plan and a **Cross-Purchase** plan is often made based on administrative simplicity rather than long-term tax efficiency. This oversight can cost surviving shareholders millions of dollars in future capital gains taxes. By analyzing the actuarial mathematics of the **Step-Up in Basis** and utilizing advanced structures like the **Trusteed Cross-Purchase**, business owners can optimize both liquidity and tax outcomes.

I. The Fundamental Divergence: Entity vs. Cross-Purchase

The core objective of both plans is identical: to use life insurance proceeds to purchase the deceased owner’s interest. However, the legal flow of funds and the resulting tax basis for the survivors differ radically.

1. The Stock Redemption (Entity Purchase) Plan

In this structure, the **Corporation** owns the policies, pays the premiums, and is the beneficiary. Upon the death of a shareholder, the Corporation uses the tax-free death benefit to redeem (buy back) the deceased’s shares.

• **The Pros:** Simplicity. The company writes one check per policy. If there are 5 shareholders, the company holds 5 policies. It is administratively clean.
• **The Cons (The Basis Trap):** When the corporation redeems the shares, the surviving shareholders’ percentage ownership increases, but their **Cost Basis** in their stock **does not change**. They have effectively acquired a larger portion of the company using corporate money, but they receive no credit for that acquisition in their personal tax basis.

2. The Cross-Purchase Plan

In this structure, the **Shareholders** individually own policies on each other. Shareholder A owns a policy on Shareholder B, and vice versa. Upon B’s death, A receives the death benefit personally and uses it to buy B’s shares from B’s estate.

• **The Pros (The Basis Step-Up):** Because Shareholder A used “personal” funds (the insurance proceeds) to buy the stock, Shareholder A receives an immediate **Step-Up in Basis** equal to the purchase price. This massive tax advantage reduces the capital gains tax liability if A eventually sells the business.
• **The Cons (The Matrix Problem):** Administrative chaos. If there are $N$ shareholders, the number of policies required is $N \times (N-1)$. For a firm with 5 partners, this requires 20 separate policies ($5 \times 4$). This complexity often drives owners back to the inferior Entity Purchase model.

II. The Mathematical Impact of the Step-Up in Basis

To understand the magnitude of the Cross-Purchase advantage, we must quantify the tax variance upon the ultimate sale of the business.

Quantitative Case Study

Imagine a company valued at $\$10$ million with two equal shareholders, A and B.

Scenario: Each has a Cost Basis of $\$100,000$. Shareholder B dies. The company value remains $\$10$ million ($\$5$ million per partner). Life insurance pays $\$5$ million to fund the buyout.

Scenario A: Stock Redemption (Entity Purchase)

The Corporation buys B’s stock for $\$5$ million and retires the shares.

Shareholder A now owns $100\%$ of the company (valued at $\$10$ million).

Shareholder A’s Basis: Remains **$\$100,000$**.

Future Sale: If Shareholder A sells the company a year later for $\$10$ million, the taxable gain is $\$9.9$ million.

Capital Gains Tax (at 20%): $\approx \$1.98$ million.

Scenario B: Cross-Purchase

Shareholder A (holding the policy) collects the $\$5$ million and buys B’s stock.

Shareholder A now owns $100\%$ of the company.

Shareholder A’s Basis: Original $\$100,000$ + New Purchase $\$5,000,000$ = **$\$5,100,000$**.

Future Sale: If Shareholder A sells the company for $\$10$ million, the taxable gain is only $\$4.9$ million ($\$10M – \$5.1M$).

Capital Gains Tax (at 20%): $\approx \$980,000$.

The Differential: The Cross-Purchase structure saved Shareholder A **$\$1,000,000$** in taxes. This “Basis Arbitrage” creates immense value simply by choosing the correct ownership structure at inception.

III. The Administrative Solution: The Trusteed Cross-Purchase (Escrow)

The “Matrix Problem” of multiple policies ($N \times (N-1)$) can be solved using a **Trusteed Cross-Purchase** (sometimes called an Insurance LLC or Escrow strategy).

1. The Structure

Instead of each partner owning policies on every other partner, the shareholders form a dedicated, third-party entity (typically a revocable trust or a special-purpose LLC) to act as the **Escrow Agent**.

The Trust owns **one policy** on each shareholder. (Total policies = $N$).

The shareholders execute a Cross-Purchase agreement with the Trust.

2. The Flow of Funds

Upon the death of Shareholder B:

1. The Trust collects the $\$5$ million death benefit tax-free.

2. Acting on behalf of the surviving Shareholder A, the Trust pays the $\$5$ million to B’s Estate in exchange for B’s stock.

3. The Trust distributes the stock to Shareholder A.

Result: Shareholder A receives the full Step-Up in Basis because the Trust acted as A’s agent. The administrative burden is identical to the Entity Purchase (one policy per person), but the tax benefits are those of the Cross-Purchase.

IV. Specialized Risks: AMT and Creditor Protection

Beyond basis, other factors influence the structural choice, particularly for C-Corporations.

1. Corporate Alternative Minimum Tax (CAMT) / E&P

For C-Corporations, an Entity Purchase plan exposes the life insurance proceeds to the **Corporate Alternative Minimum Tax (AMT)** (for very large corporations) or increases the corporation’s **Earnings and Profits (E&P)**.

The Trap: Death benefit proceeds are generally income-tax-free, but they do increase E&P. If the C-Corp subsequently distributes these funds to shareholders (rather than using them for the buyout), the distribution is taxed as a dividend. A Cross-Purchase completely bypasses the corporate tax return, eliminating this risk.

2. Asset Protection

In an Entity Purchase, the cash value of the policies is a corporate asset. It is reachable by the corporation’s general creditors. If the company is sued, the funding for the buyout could be seized.

In a Cross-Purchase (or Trusteed structure), the policies are owned by individuals or a separate trust, typically placing them **outside the reach of corporate creditors**, thereby securing the buyout funding against business liability.

V. Handling the Departure of a Partner (The “Transfer for Value” Risk)

When a partner leaves (retires or is bought out) in a standard Cross-Purchase, they own policies on the lives of the remaining partners. These policies must be transferred to the remaining partners to maintain the funding.

The Danger: Selling a policy from Departing Partner A to Remaining Partner B is a **Transfer for Value**. As discussed in previous analyses, this destroys the tax-free death benefit unless an exception applies.

The Trusteed Advantage: In a Trusteed/LLC structure, the entity owns the policies. When a partner leaves, the entity continues to hold the policies on the remaining partners. No transfer of policy ownership occurs; only the LLC membership interest changes. This elegant structure avoids the Transfer for Value trap entirely.

VI. Fiduciary Conclusion

While the Entity Purchase is convenient, it is mathematically inferior for the surviving owners due to the forfeiture of the basis step-up. For any company with an anticipated value exceeding the small business threshold, the **Trusteed Cross-Purchase** represents the optimal convergence of tax efficiency (step-up), administrative simplicity (one policy per person), and asset protection.

Disclaimer: This content is for informational purposes only and does not constitute legal or tax advice. Buy-Sell Agreements are legal contracts that govern the equity of a business; they should be drafted by competent corporate counsel in conjunction with a tax advisor.