A Buy-Sell That No Longer Fits the Business or the Owners

Cross-purchase mechanics here are strained. With three owners you need n(n-1) = six policies, each priced to the insured's age and health. Alan's cardiac event breaks the machine: the policies Beth and Carl own on Alan cannot be replaced at reasonable cost, and if Alan dies, Beth and Carl each receive $500,000 and each must buy Alan's shares from his estate. When Carl exits, Alan and Beth must each apply for new coverage on the other, which for Alan may be impossible.

Cross-purchase advantage: buyers receive a cost basis equal to the purchase price. With stock worth $9 million and a $600,000 basis, basis to the survivors matters enormously for their own eventual exit.

Redemption advantage: simplicity when the group shrinks, and it uses corporate cash ($1.2 million available plus a line of credit). Carl's redemption would be a complete termination of his interest under section 302(b)(3), producing sale treatment rather than a dividend, provided he files the family-attribution waiver. The cost is that the corporation, not the survivors, ends up holding the shares, and the survivors get no basis increase.

Recommendation: a hybrid. Use a redemption for Carl's exit, where complete termination relief is clean and the corporation has cash, and keep a one-way cross-purchase between Alan and Beth for the post-exit period, funded with new policies underwritten while Alan's health status is at least known. Revisit the structure now, not in 2030.

The price is a pro rata number with no valuation discipline. $6,000 per share times 2,000 shares equals 20% of the $6 million appraisal, which values a noncontrolling minority interest as if it could command a control premium. A defensible fair market value for a 20% interest, after minority and marketability discounts of, say, 15% to 30%, is roughly $850,000 to $1.05 million. The fixed price has not been touched in a decade and has no adjustment mechanism.

Consequences:

• Direction of drift. If the company keeps growing, a stale fixed price systematically under-pays the departing family. Carl receives $1.2 million for shares that may be worth $1.8 million in 2030; his estate is the loser.
• Tax mismatch. The estate's basis steps up to fair market value at death. If the buy-sell price is below fair market value, the estate sells at a loss, realizing less cash than the shares are worth; the loss deduction does not make the family whole.
• IRS exposure. A buy-sell price is respected only as a bona fide arm's-length arrangement. A price set when the company was worth $2.5 million and never revisited invites an estate tax valuation fight.

Fix: replace the fixed price with a formula tied to an independent appraisal, reviewed annually, with a defined method (book value plus a multiple, or appraisal) and a floor/ceiling. Do this now, while everyone is alive, healthy, and can consent.

1. Size the policies to the actual obligation, not to a flat number. Carl's 20% at $1.2 million would be bought pro rata: Alan buys $750,000 (50/80), Beth buys $450,000 (30/80). Each currently owns only $500,000 on Carl, so Alan is underfunded and Beth is overfunded. Similarly, Beth and Carl's obligations on Alan's death are $937,500 and $562,500 respectively.

2. Match policy duration to the exit date. The 2015 policies expire in 2035, but Carl could exit in 2030; the coverage must be in force on the day the obligation is triggered. Use permanent coverage or level term with a guaranteed renewal provision rather than a term that may lapse before the purchase.

3. Add a disability buy-out. There is no disability provision, which is the largest gap for an engineering firm whose value is tied to the owners' continued work. Specify a waiting period (commonly 90 to 180 days), a definition of disability tied to occupation, and funding through a disability buy-out policy or the line of credit.

4. Address Alan's uninsurability. Either fund Alan's obligation through the corporation, or use a partial self-funding schedule. Recognize that if Alan dies first, his 50% passes to his estate and the survivors' $1.5 million of aggregate coverage on him is only 40% of a $3 million obligation.

5. Add a mandatory purchase at death, a valuation review clause, and a trusteed arrangement so the agreement is administered independently of the parties' willingness to cooperate.