A cross purchase is similar to redemption with one big twist. The purchaser of the parent’s stock is another shareholder individual, not the corporation. In our case, Steve and Betty would still continue to be paid principle and interest payments over a long-term for as long as 15 years but the payments would come from Dave, not from the company. How does a cross purchase strategy compare with the redemption approach?
The cross purchase offers some significant benefits. The biggest impediment to the redemption approach, the complete goodbye requirement is gone. The parents can stay involved in the business as much as and for as long as they want. Steve can remain on the board and can keep his hands in the operation to the extent he chooses, plus there is no requirement that all of the parent’s stock be sold in a single transaction – piecemeal sales work. Plus, Dave’s tax basis in the purchase stock will equal the purchase price he pays for the stock. Unlike the redemption approach, the amounts paid to Steve and Betty in a cross purchase produce a basis increase for the other shareholders.
Apart from these benefits, the cross purchase approach has many of the same limitations and disadvantages as the redemption approach. Principle payments on the installment note must be funded with after-tax dollars, a costly requirement. Dave’s credit capacity may be tapped. The payments to the parents will not extend beyond the contract term. There is no basis step-up in the contact rights on the parent’s death. That is, when the heirs get the remaining contract balance amounts. Payments under the contact received by other family members, Kathy and Paul, for example, following the deaths of the parents will be subject to full income taxes.
Plus, the cross purchase approach presents a whole new problem. Where is Dave going to get the cash to cover the payments for the stock? This problem alone often eliminates the cross purchase option in many situations. If Dave has an independent source of income or cash that he is willing to commit to the deal, then this funding problem is solved. Absent such an independent source, Dave will be forced to turn to the corporation for the cash. This can be tough, often insurmountable.
The extra compensation payments that would need to be paid to Dave must be large enough to cover the current interest payments on the note, the after-tax principle payments on the note, and the additional income and payroll taxes that Dave will be required to pay as a result of the increased compensation. Beyond the cash burden to the corporation, if the compensation payments to Dave are unreasonably high, there may be a constructive dividend risk that could put the corporation’s deduction in jeopardy. Corporate loans to Dave might be an option but these types of corporate loans always present serious problems. The loans themselves will need to be repaid at some point down the road with after-tax dollars. They may simply defer and magnify the scope of the problem.
This difficult funding challenge often requires a combination approach that integrates a cross purchase with a gift or a redemption strategy or both. The parents may gift some stock and have the balance of their stock redeemed by the corporation or purchased by other family members. The benefit of a combination approach is that the disadvantage of each strategy is watered down because only a portion of the stock is subject to that strategy.