Cross-Purchase Agreements: A Powerful Solution for Business Continuity in Canada

Cross-Purchase Agreements and Life Insurance: A Powerful Solution for Business Continuity in Canada
Cross-Purchase Agreements and Life Insurance: A Powerful Solution for Business Continuity in Canada

A cross-purchase agreement funded by life insurance can provide a robust continuity plan for private Canadian companies. This article explores how cross-purchase agreements work, their benefits, and how to implement them properly.

What Exactly is a Cross-Purchase Agreement?

What Is a Cross-Purchase Agreement . How Much Does It Cost
What Is a Cross-Purchase Agreement . How Much Does It Cost

A cross-purchase agreement is a legally binding contract between business partners or shareholders. It stipulates the terms for transferring or selling a partner’s shares if they pass away, become disabled, or retire.

In this type of buy-sell agreement, the surviving partners purchase life and disability insurance policies for each other. If an insured event occurs, the payout from the policy provides liquidity for partners to buy the departing partner’s shares.

Why Cross-Purchase Agreements in Canada Make Sense

  • 97,000 of Canadian new business owners have a buy-sell agreement in place. (Source)
  • Of those with an agreement, most use life insurance to fund it.
  • The most common triggers covered are death, disability, and retirement.

There are several compelling reasons why cross-purchase agreements are commonly used for continuity planning:

  • Immediate liquidity – Life insurance provides funds instantly when needed for buyouts.
  • Tax-free proceeds – Death benefits are received tax-free, avoiding erosion of capital.
  • Continued control – Keeping shares within the company allows remaining owners to maintain control.
  • Fair valuations – The agreement sets a formula for share pricing to prevent disputes.
  • Customization – Terms can be tailored based on owners’ specific needs.

Read more: Buy-Sell Agreements in Canada

How Much Do Cross-Purchase Agreements Cost in Canada?

The costs of implementing a cross-purchase agreement consist primarily of:

Premiums for Life Insurance Policies

The biggest cost is paying the yearly premiums for the life insurance policies taken out on each business partner. Premiums depend on:

  • Age and health of insured partners
  • Type of policy (term, whole life, etc.)
  • Amount of death benefit needed

For example, $1 million of term life insurance coverage for a 40-year-old partner could cost approx. $500/year.

Professional Fees

Attorney fees to draft the agreement can range from $1,500 – $5,000. Some advisors charge fees for assistance in setting up the policies and documentation.

Ongoing legal and advisor fees may also be incurred for periodic reviews and updates to policies/agreements.

Total Costs

For example, for a business with three partners taking out $500,000 policies, total first-year costs could be:

  • Premiums: 3 x $300 (estimated) = $900
  • Legal fees: $3,000
  • Total: Approx. $3,900

Then, just the annual premium payments of around $900/year thereafter.

Benefits of Cross-Purchase Agreements

Benefits and Drawbacks of Cross-Purchase Agreements
Benefits and Drawbacks of Cross-Purchase Agreements

Provides Funds for Buyouts

The life insurance policies ensure funds are available when needed to buy out a deceased or departing partner’s shares. This prevents business disruptions.

Allows Business Continuity

With the buyout funds readily accessible, operations can continue smoothly even after a partner’s departure.

Avoids Disputes

The agreement’s valuation terms prevent conflicts between remaining partners and heirs over the share price.

Provides Flexibility

Owners can customize the agreement to fit their specific continuity objectives.

Tax-Free Proceeds

The life insurance payout is income tax-free, maximizing available buyout capital.

Drawbacks of Cross-Purchase Agreements

Administrative Complexity

Can become complicated tracking all policies for a larger number of partners. A trusteed agreement may be easier.

Ongoing Updates

The policies must be continually reviewed and updated as partners and business conditions evolve.

After-tax dollars for Premiums

Premiums are typically not tax deductible and must be paid with after-tax money.

Using Life Insurance to Fund Cross-Purchase Agreements

Life insurance provides several key advantages for funding cross-purchase agreements:

Cost-Effective Premiums

Premiums are much lower than the capital required to pre-fund a buyout, allowing those funds to be invested in growth.

Tax-Advantaged Proceeds

The tax-free death benefit avoids erosion of capital. Premiums may also be deductible in some cases.

Immediate Liquidity

Proceeds are available immediately upon the death of a partner to facilitate a quick buyout.

Customizable Policies

Can choose term life insurance, whole life insurance, universal life insurance, or survivorship life insurance based on business needs.

Read more: Corporate-Owned Life Insurance in Canada

Reputable Insurance Providers

Leading options in Canada include SunLife, Canada Life, RBC Insurance, and Manulife.

Transferable Policies

If a partner departs, their policy can be transferred to the new partner.

Regular reviews ensure policies align with evolving business conditions.

How To Implement Cross-Purchase Agreements

Key implementation steps include:

  • Engaging legal counsel to draft the agreement
  • Selecting a valuation method for establishing share price
  • Acquiring individual life insurance policies for each partner
  • Finalizing all documentation like beneficiary designations
  • Scheduling periodic reviews to update policies as needed

There are also important tax considerations:

  • Premiums are typically not tax-deductible
  • Proceeds received by beneficiaries are non-taxable
  • Transferring policies could trigger capital gains in some cases

Consulting tax and legal experts is highly recommended.

Tips for Purchasing Cross-Purchase Agreements

Tips for Purchasing Cross-Purchase Agreements
Tips for Purchasing Cross-Purchase Agreements

Shop Multiple Insurers

Compare premium costs across insurers to find competitive rates.

Index Valuation Formula

Build in indexing to the valuation to account for inflation over time.

Conduct Regular Reviews

Periodically review policies to ensure optimal coverage as needs evolve.

Match Policy Type to Objectives

Choose term, permanent, or survivorship life insurance based on business goals.

Alternatives to Cross-Purchase Agreements

While cross-purchase agreements have many advantages, there are also some alternatives:

Wait-and-See Buy-Sell Agreement

Doesn’t define buyout terms until an event occurs. Provides more flexibility but less certainty.

One-Way Buy-Sell Agreement

Only one partner is obligated to purchase shares. Lower insurance costs but less reciprocity.

Redemption Agreement

The business buys policies for each owner. Simple to manage but less control for partners.

Trusteed Buy-Sell Agreement

Policies are owned by a trust. Often used for larger partnerships. Adds annual trustee expenses.

Evaluate each company’s situation to determine the optimal arrangement that aligns with their objectives.

Conclusion: The Bottom Line for Advisors

  • Cross-purchase agreements funded by life insurance provide robust continuity planning for private Canadian businesses.
  • This allows companies to continue smoothly in the event of an owner’s untimely death or departure.
  • Life insurance funding offers advantages like affordable premiums, immediate liquidity, and tax-free proceeds.
  • With proper setup guidance and ongoing maintenance, advisors can deliver tremendous value to business owner clients while also generating revenue.
  • Helping to safeguard a company’s future often leads to many referrals and a loyal client for life.

Equipping business clients with cross-purchase agreements and life insurance is one of the most rewarding services an advisor can provide. Let this guide support you in offering truly holistic counsel that secures your clients’ financial futures.

How are cross-purchase agreements taxed in Canada?

In Canada, premiums paid for policies within a cross-purchase agreement are typically not tax deductible. However, any payouts received by beneficiaries are non-taxable income. Transferring policies could trigger capital gains in some cases.

What happens to a cross-purchase agreement if a partner goes bankrupt?

The bankruptcy trustee may require the bankrupt partner's shares to be purchased by the surviving partners per the agreement terms. The life insurance payout can provide the funds.

Where should a cross-purchase agreement be kept?

Experts recommend keeping original copies of the agreement in secure locations accessible to partners, like safe deposit boxes. Digital copies should also be stored securely.

Why choose a cross-purchase over a redemption agreement?

Cross-purchase agreements allow partners more control over policies. They also provide a step-up in cost basis when acquiring a departed partner's shares.

When should you update a cross-purchase agreement?

Agreements should be reviewed periodically, especially when partners change, business values shift substantially, or policy terms need renewal.

Do all partners need life insurance in a cross-purchase agreement?

Yes, the premise involves all partners being insured to provide buyout funds in case any partner dies or departs. The policies can have different coverage amounts.

Can a cross-purchase agreement obligate heirs?

Yes, heirs can be contractually obligated to sell a deceased partner's shares. The life insurance payout provides the funds.

Is a cross-purchase agreement a will substitute?

No. A cross-purchase agreement only deals with business succession, not distribution of personal assets. A will still is recommended.

How does a cross-purchase agreement affect taxes?

Several tax considerations come into play. Experts recommend consulting tax professionals when structuring the agreement.

What happens if proceeds are insufficient for a buyout?

The agreement should outline secondary funding options, like business cash reserves or bank financing, if life insurance proceeds fall short.

How long does a cross-purchase agreement last?

Agreements should include terms for renewal, to account for evolving insurance needs over time as partners age or business conditions change.

Can a cross-purchase agreement be cancelled?

Yes, partners can mutually agree to cancel or modify an agreement. Proper legal documentation is required.

Is a cross-purchase agreement the same as a shotgun clause?

No. Shotgun clauses only give one partner the option to make a buyout offer. Cross-purchase agreements are reciprocal between partners.

What valuation methods can be used in a cross-purchase agreement?

Common valuation methods include book value, revenue multipliers, appraisals, and set formulas based on assets and profits.

How does the death benefit get paid out in a cross-purchase agreement?

Surviving partners are beneficiaries on the deceased partner's policy. The insurer pays them the death benefit to fund the buyout.

Who owns the life insurance policies in a cross-purchase agreement?

The partners own policies on each other. This contrasts with redemption agreements where the company owns policies on owners.

How are partnership cross-purchase agreements taxed?

The partnership pays no tax on receiving the death benefit. The payment to a deceased partner's estate may face capital gains tax.

What happens if partners dispute a cross-purchase agreement?

Courts typically enforce properly executed agreements. Valuation terms should aim to prevent disputes. Mediation can provide alternatives.

When does a partner need to notify others about health changes?

The agreement should require prompt notification of any health events that could impact insurability or policies. Failing to disclose may invalidate a policy.

How should partners withdraw from a cross-purchase agreement?

Partners should follow outlined procedures to resign from the business and transfer policies to remaining partners per the agreement terms.

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  1. Cross-Purchase Agreement: What it Means, How it Works –
  2. Buy/Sell agreements – Crisscross method –
  3. Mastering Buy-Sell Agreements: A Guide to Ensuring Business Continuity in Canada –
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Written by Ben Nguyen

Ben Nguyen is an award-winning insurance expert and industry veteran with over 20 years of experience. He is the chairman and director of IDC Insurance Direct Canada Inc., one of Canada's leading online insurance brokerages.

Ben is renowned for his extensive knowledge of life, health, disability, and travel insurance products. He is the prolific author of over 1,000 educational articles published on LifeBuzz, BestInsuranceOnline, and InsuranceDirectCanada. His articles provide Canadians with advice on making smart insurance decisions.

With a Bachelor's degree in Actuarial Science and a Fellow of the Canadian Institute of Actuaries (FCIA) designation, Ben is frequently interviewed by media as an insurance industry spokesperson.

He has received numerous honors including the Insurance Council of Canada’s Pivotal Leadership Award, the Canadian Insurance Hall of Fame induction, and the President’s Medal from the Canadian Institute of Actuaries.

Ben continues to shape the vision and strategy of IDC Insurance Direct as chairman. He is dedicated to advancing the insurance industry through his insightful leadership.

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