CROSS PURCHASE AGREEMENTS CAN DEFINE THE TRANSFER OF OWNERSHIP BETWEEN PARTNERS, SHAREHOLDERS, OR LLC MEMBERS WITHOUT THE HASSLE
One of the most common types of buy-sell agreements in small businesses is called a “cross-purchase” agreement.
A cross-purchase agreement involves a partner/shareholder/LLC member purchasing the ownership interest of another partner/shareholder/LLC member who is leaving the business. These written agreements are almost always entered into by the owners prior to their anticipated retirement or separation from the company. Cross-purchase agreements set out the terms of a partner/shareholder/member’s departure, including the compensation they will receive and who will have the first right to purchase their shares/interest in the enterprise. This pre-planning helps avoid negative conflicts over the material details of the separation, including compensation and other transfer issues that may otherwise arise.
Cross-purchase agreements are beneficial in many other ways. Pre-planning arrangements allow for funding the compensation due to the departing shareholder, partner, or LLC members, which typically requires obtaining cash or other payment methods when the agreement is signed. Pre-planning for the buyout mitigates liquidity issues when one partner/shareholder terminates their interest. When the owner decides to leave the business, you get the money immediately.
Cross-purchase agreements are also beneficial because they do not involve the business entity directly. They merely involve one or more partners/shareholders/LLC members purchasing the ownership interest from the other partner(s)/shareholder(s)/LLC member(s), without the business entity being involved at all. This distinguishes it from the other main type of buy-sell agreement, a “redemption” agreement, which involves the business itself purchasing the departing partners’ shares in the company. By predetermining who will purchase their interest, a cross-purchase agreement allows a departing majority shareholder, for example, to control in advance who will receive their majority interest in the business upon their departure. This prevents any second-guessing a potential buyer may have later.
Cross-purchase agreements also allow those who do not wish to purchase additional shares in the company to remain outside the agreement. Not the case with a redemption agreement. In a redemption agreement, the company itself buys out the departing shareholder, meaning each remaining shareholder is forced to acquire more shares, something minority shareholders may not want to do. Cross-purchase agreements also assure partners/shareholders that a departing member cannot sell their stake in the company to an unrelated or undesirable third party, preventing an outsider from taking over the business. Overall, the predetermined buyer prevents any last-minute surprises for the seller, buyer, and other shareholders in the company.
As for the economics of the agreement, a cross-purchase agreement, like all other buy-sell agreements, can establish a predetermined business value, which is beneficial for tax purposes for businesses that are likely to increase in value. However, in order for the government to honor such a predetermined value, three strict conditions must be met:
- The agreement must be a bona fide business agreement.
- The agreement must be clearly not a device to transfer the business to members of a decedent’s family for less than full and adequate consideration.
- The terms of the agreement must be comparable to similar arrangements entered into by non-parties.
These conditions prevent partners/shareholders from using cross-purchase agreements to avoid paying capital gains and/or gift tax.
A properly crafted cross-purchase agreement can be a valuable document that assures small business partners, LLC members, and shareholders that, if they leave the business, they will be compensated in accordance with the agreement’s terms. It is important that these agreements are properly constructed and the appropriate regulations are followed. If not properly written, they can lead to undesirable, surprising results.
Fredrick P. Niemann Esq.
If you are interested in learning more about cross-purchase agreements or redemption agreements, please contact Fredrick P. Niemann, Esq., a practical business attorney with years of experience in buy-sell and redemption agreements. He can be reached at (732) 863-9900 or by email at fniemann@hnlawfirm.com. He would be happy to answer any questions you may have. Call him today.
Written by Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a New Jersey Business Law Attorney