M&A: Stock Cross-Purchase Strategy

A cross purchase is similar to a redemption approach 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 principal 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 purchased 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.

Principal 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 contract rights on the parent’s death. That is, when the heirs get the remaining contract balance amounts. Payments under the contract 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 find the capital to fund the stock payments? 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 principal 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.

Cross Purchase vs. Redemption: A Structural Comparison

The choice between a cross purchase and a corporate redemption is one of the most consequential structural decisions in a closely held business succession. The differences go well beyond who writes the check; they affect tax basis, estate planning, creditor exposure, and the ongoing relationship between generations of ownership.

In a redemption, the corporation buys back the departing owner’s shares directly, which reduces the company’s equity base and may trigger dividend treatment under certain circumstances—particularly in family ownership situations where the attribution rules apply. In a cross purchase, the continuing shareholder (Dave, in our example) acquires the shares individually, which gives him a stepped-up cost basis equal to what he paid. That basis difference matters significantly if Dave eventually sells his stake, because a higher basis reduces the capital gain he recognizes on exit.

For a detailed comparison of how these two approaches are weighed against each other in practice—including the insurance funding angle that many advisors recommend—see the related discussion on buy-sell agreement structuring: redemption vs. cross-purchase trade-offs.

The Funding Problem in Detail

The funding challenge in a cross purchase is real and deserves more attention than it typically receives in introductory treatments of the topic. There are four primary mechanisms practitioners use to address it, each with its own set of trade-offs:

• Life or disability insurance on the departing owner: If the cross purchase is triggered by death or disability, insurance proceeds can fund the purchase cleanly without tapping corporate cash. This is the most efficient mechanism when the triggering event is insurable.
• Installment sale from corporate compensation: The corporation pays Dave additional compensation, which he uses to service the installment note. This is taxable to Dave as ordinary income and must be sized carefully to avoid the constructive dividend risk described above.
• Third-party financing: Dave borrows from a bank or institutional lender, with the purchased shares (or other assets) pledged as collateral. Lender appetite for this type of deal varies considerably depending on the creditworthiness of both the borrower and the underlying business.
• Combination approach: As noted, splitting the transaction—part gift, part cross purchase, part redemption—allows each mechanism to handle the portion of the deal it is best suited for, reducing the overall burden on any single funding source.

Tax Basis Implications for the Continuing Owner

The basis advantage of a cross purchase over a redemption is often the deciding factor for continuing shareholders who expect to eventually sell. When Dave purchases Steve and Betty’s shares directly, his aggregate basis in the company rises by the full purchase price. In a corporate redemption, Dave’s basis stays flat—only the corporation’s equity account changes.

This distinction compounds over time. If the business appreciates significantly before Dave’s own exit, the difference in basis translates directly into a difference in capital gains tax liability. Advisors running a deal of any size will typically model both scenarios with projected holding periods and exit multiples before recommending a structure.

It is also worth noting that using stock as consideration in M&A introduces its own basis mechanics, particularly in reorganization transactions where carryover basis rules apply—a reminder that basis planning is not unique to family succession but runs through nearly every business transfer scenario.

When the Combination Approach Makes the Most Sense

Practitioners reach for the combination approach most often when three conditions are present simultaneously: the departing owner’s total equity stake is large relative to the continuing owner’s personal financial capacity, the corporation’s cash position cannot absorb a full redemption without impairing operations, and estate planning considerations make a partial gift strategically attractive from a transfer-tax standpoint.

In these situations, structuring the transaction as a partial gift (reducing the purchase obligation), a partial cross purchase (giving Dave the basis step-up on what he buys), and a partial redemption (letting the corporation absorb what remains) can distribute the tax and cash-flow burden across all three mechanisms. The result is often a more workable deal—even if the legal documentation and coordination across advisors is more complex. For owners also evaluating an ESOP as an alternative exit vehicle, it is worth noting that ESOPs can sometimes be layered into a combination approach as well, particularly in C-corporation contexts where the Section 1042 rollover is available.

If you are working through a business transfer and want to map the structural options against your specific ownership, tax, and timing constraints, preparing a transaction overview is a practical first step toward getting advisor-level clarity on which structure fits best.

Frequently Asked Questions

What does “cross purchase” mean in the context of a buy-sell agreement?

A cross purchase is a buy-sell structure in which a departing owner’s shares are purchased by one or more of the remaining individual shareholders rather than by the corporation itself. The distinction matters for tax basis, estate planning, and the source of funding for the purchase price.

Why does the cross purchase give the buying shareholder a higher tax basis than a redemption would?

When a shareholder buys stock directly, their cost basis in the company equals what they paid. In a corporate redemption, the company buys the shares back—the remaining shareholders’ individual basis does not change. A higher basis reduces capital gains exposure when the buying shareholder eventually exits.

How do advisors typically address the funding gap in a cross purchase?

Common solutions include life or disability insurance (for death- or disability-triggered buyouts), additional compensation from the corporation (which Dave uses to service the installment note), third-party bank financing, or a combination approach that blends cross purchase, redemption, and gifting to distribute the financial burden across multiple mechanisms.

Can a cross purchase and an ESOP be used together?

In some circumstances, yes. An ESOP can purchase a portion of the departing owner’s shares while a continuing shareholder purchases the remainder through a cross purchase. The feasibility depends on the company’s ownership structure, the ESOP’s borrowing capacity, and the tax objectives of the parties involved. This type of layered structure typically requires close coordination among legal, tax, and financial advisors.