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Hong KongBusiness insurance: key person, buy-sell and the basis difference
A cross-purchase has the owners buy each other out and gives the survivors a stepped-up basis; an entity redemption has the business buy the interest and does not. Life insurance funds either, and the number of policies differs sharply.
A small topic with a clean set of distinctions, which makes it good exam material.
The two structures
| Cross-purchase | Entity redemption | |
|---|---|---|
| Who buys | The surviving owners | The business |
| Who owns the policies | Each owner on the others | The business |
| Policies needed for n owners | n times n minus one | One per owner |
| Basis for survivors | Increased by the purchase price | Unchanged |
| Creditor exposure of the policies | Lower | Business creditors can reach them |
The policy count is the practical driver. Two owners need two policies under a cross-purchase; five owners need twenty. That is why larger groups use an entity arrangement or a trusteed structure.
The basis difference
This is the examinable point and the reason the structure matters beyond administration.
Under a cross-purchase, the surviving owners have bought the departing interest personally, so their basis increases by what they paid. If they later sell the business, the gain is smaller.
Under a redemption, the company bought it. The survivors own a larger share of the company with no increase in their own basis, so a later sale produces a larger gain.
Restructuring a buy-sell can transfer policies between owners for consideration, which risks the transfer-for-value rule and the loss of the income tax exclusion on the death benefit. The exceptions - transfer to the insured, to a partner, or to a partnership in which the insured is a partner - are what make the planning work.
Valuation
The agreement should set a method: a fixed price reviewed periodically, a formula, or an independent appraisal at the time.
A fixed price that has not been reviewed for a decade is the standard problem, and an agreement can fix the value for estate tax purposes only if it meets specific requirements - including being binding during life as well as at death and being comparable to an arm's length arrangement.
Key person insurance
Owned by and payable to the business, on a person whose loss would materially damage it. Premiums are not deductible; the death benefit is generally received tax free, subject to notice and consent requirements for employer-owned policies.
It funds recruitment, lost profits and creditor reassurance rather than a purchase of ownership, which is what distinguishes it from a buy-sell policy.
Business overhead expense
Disability cover that pays business fixed costs - rent, salaries, utilities - while the owner is disabled. Premiums are deductible and benefits are taxable, which is the reverse of personal disability cover.
That reversal is a clean examinable contrast, and it is the sort of detail that separates candidates who read the domain from those who skimmed it.
Dollar limits here are indexed annually and several were changed by recent legislation. Confirm the current figure before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What is the difference between a cross-purchase and an entity redemption?
In a cross-purchase the surviving owners buy the departing interest and their basis increases. In a redemption the business buys it and the survivors' basis is unchanged, producing a larger gain on a later sale.
How many policies does a cross-purchase need?
For n owners, n times n minus one. Two owners need two policies; five owners need twenty, which is why larger groups use entity or trusteed arrangements.
Is key person insurance deductible?
No. Premiums are not deductible, and the death benefit is generally received tax free subject to the notice and consent requirements for employer-owned policies.
How is business overhead expense insurance taxed?
Premiums are deductible and benefits are taxable - the reverse of personal disability insurance, which is a clean examinable contrast.
Can a buy-sell agreement fix the estate tax value?
Only if it meets specific requirements, including being binding during life as well as at death and being comparable to an arm's length arrangement.