If your company has a buy-sell agreement that uses life insurance to redeem shares upon an owner’s death, a recent U.S. Supreme Court decision could significantly impact you or your heirs. The ruling in Connelly v. United States may lead to increased estate tax liability and a higher valuation of a deceased owner’s shares than expected.
This decision underscores the need for business owners to review and potentially revise their buy-sell agreements to avoid unexpected tax consequences.
What Happened in Connelly?
Two brothers, Thomas and Michael Connelly, co-owned Crown C Supply, a building supply business. To ensure the business’s continuity in the event of either brother’s death, they established a stock redemption agreement. Their corporation purchased life insurance policies on each brother’s life, with the intent to use the proceeds to redeem the deceased shareholder’s shares.
Key Events:
- Michael Connelly passed away in 2013.
- Crown C Supply received $3 million in life insurance proceeds and used the funds to redeem Michael’s shares.
- Michael’s estate valued his shares at $3 million, following the redemption agreement.
- The IRS disagreed, arguing that the life insurance proceeds should be included in the company’s value, increasing it to $6.86 million.
- This higher valuation increased the estate tax liability, requiring Michael’s estate to pay additional taxes.
- After losing in district court, the Eighth Circuit Court of Appeals, and ultimately the U.S. Supreme Court, the IRS’s position was upheld.
Supreme Court Ruling:
The Court unanimously ruled that life insurance proceeds used in a stock redemption increase the company’s value for estate tax purposes. A company’s obligation to redeem shares does not offset the increase in business value from receiving life insurance proceeds.
This decision directly impacts business owners who use life insurance in stock redemption buy-sell agreements.
How the Connelly Decision Affects Business Owners
The Supreme Court ruling in Connelly clarifies that:
- Life insurance proceeds received by a company increase the company’s value for estate tax purposes.
- The deceased owner’s estate could face a higher tax bill because their shares may now be valued higher than expected.
- Corporate-owned life insurance in a redemption agreement no longer provides a tax shield against estate tax liability.
Example Impact:
Before Connelly, many business owners assumed that if a company received $3 million in life insurance to redeem shares, the company’s value would not increase by that amount. However, Connelly confirms that the IRS can and will include these proceeds in the company’s total valuation.
This ruling means that many existing redemption buy-sell agreements may now lead to higher estate taxes than business owners originally planned.
What Should Business Owners Do Now?
If your buy-sell agreement relies on company-owned life insurance, now is the time to reassess your estate and tax planning strategy. Consider the following steps:
1. Determine If Your Estate Will Be Affected
- Current estate tax exemption: The federal estate tax exemption is $13.61 million per individual in 2024.
- Future estate tax exemption: The Tax Cuts and Jobs Act (TCJA) expires in 2025, potentially reducing the exemption by half in 2026.
- If your estate is valued below the exemption, you may not need to make changes.
- However, state estate taxes may still apply, as some states have much lower exemptions.
2. Consider Switching to a Cross-Purchase Agreement
A potential alternative is a cross-purchase buy-sell agreement, where:
- Each business owner purchases life insurance on the others.
- The individual owners, not the company, receive the life insurance proceeds.
- They then use the proceeds to buy the deceased owner’s shares.
Benefits of a Cross-Purchase Agreement:
- Life insurance proceeds are not included in the company’s valuation.
- Owners receive tax-free life insurance benefits.
- Surviving owners get an increased stock basis, reducing future capital gains taxes.
3. Consider a Cross-Purchase Trust or Insurance LLC
A cross-purchase trust or an insurance LLC can simplify life insurance ownership in businesses with multiple owners:
- Rather than having each owner hold policies on every other owner, the trust or LLC owns all policies.
- When an owner dies, the trust/LLC uses the proceeds to buy shares.
This structure avoids estate tax complications and ensures policy premiums are paid consistently.
Key Takeaways
- The Supreme Court’s ruling in Connelly confirms that life insurance proceeds increase a company’s value for estate tax purposes.
- Business owners with buy-sell agreements using corporate-owned life insurance should review their agreements with tax and legal advisors.
- If estate taxes are a concern, consider transitioning to a cross-purchase agreement, where individual owners own life insurance policies on each other.
- Alternatives like a cross-purchase trust or insurance LLC can help manage policies for businesses with multiple owners.
Business succession planning is critical for minimizing tax burdens and ensuring a smooth transition. Now is the time to consult an estate planning professional to reassess your buy-sell agreement and protect your business and heirs from unintended tax consequences.
