The recent U.S. Supreme Court decision in Connelly v. United States has significantly impacted how closely held companies approach buy-sell agreements, particularly those funded by corporate-owned life insurance policies. The ruling clarified that life insurance proceeds received by a corporation to fulfill a stock redemption obligation must be included in the corporation’s valuation for federal estate tax purposes, without any offset for the contractual purchase obligation.
This pivotal decision necessitates a reevaluation of buy-sell strategies to ensure tax efficiency, safeguard business continuity, and protect shareholder interests.
Key Takeaways from the Connelly Decision
At its core, the Connelly ruling underscores the critical tax implications of entity-purchase buy-sell agreements funded by life insurance. Traditionally, many business owners used corporate-owned policies to fund stock redemptions upon a shareholder’s death. However, Connelly established that life insurance proceeds increase the corporation's value for estate tax purposes, regardless of redemption obligations.
This ruling has two primary consequences:
Increased Estate Tax Liability: The inclusion of life insurance proceeds in the corporation’s value inflates the deceased shareholder’s taxable estate. This could result in higher estate taxes, reducing the amount passed to heirs.
Complex Valuation Issues: If the redemption price is lower than the estate tax valuation of the shares, the estate may recognize a loss that cannot always be used advantageously.
These outcomes present a significant challenge for businesses reliant on entity-purchase agreements, necessitating a reassessment of buy-sell agreements.
Structuring Buy-Sell Agreements Post-Connelly
The Connelly decision does not eliminate the viability of life insurance in buy-sell planning, but does require careful structuring to mitigate its tax impact. Here are key strategies for businesses to consider.
One: Cross-Purchase Agreements
A cross-purchase agreement shifts the obligation to purchase shares from the corporation to the individual shareholders. Each shareholder personally owns life insurance policies on the lives of the other shareholders. Upon the death of an owner, the surviving shareholders use the proceeds to buy the deceased’s shares directly.
Benefits:
Life insurance proceeds are not included in the corporation’s value, avoiding the estate tax issue highlighted in Connelly.
Surviving shareholders benefit from a stepped-up basis in the purchased shares, potentially reducing future capital gains taxes.
Challenges:
Administrative complexity increases with multiple shareholders, as each must purchase policies on the others.
Premium disparities can arise if shareholders differ significantly in age or health.
Two: Hybrid Buy-Sell Agreements
A hybrid approach combines elements of entity-purchase and cross-purchase agreements. The corporation may handle part of the purchase through smaller insurance policies, with individual shareholders using promissory notes or installment payments for the remainder.
Advantages:
Reduces the size of corporate-owned policies, minimizing estate tax implications.
Balances administrative simplicity with tax efficiency.
Three: Life Insurance LLCs
To simplify administration and avoid corporate ownership, businesses can establish a separate LLC to own life insurance policies. The LLC is treated as a partnership for tax purposes, with each member’s ownership interest proportionate to their share in the business.
Benefits:
Policies are centralized, requiring only one policy per insured.
Death benefits are distributed through the LLC, avoiding corporate valuation increases.
Example: In a closely held company with four shareholders, the LLC owns policies on each individual. Upon a shareholder’s death, the LLC collects the death benefit and allocates it to the surviving members, who then use the funds to buy the deceased’s shares. This approach simplifies policy administration and prevents transfer-for-value complications.
Practical Steps for Business Owners
Given the potential tax exposure under Connelly, business owners should take proactive measures to assess and adapt their buy-sell agreements. Key steps include:
Review Existing Agreements: Work with advisors to determine whether your current structure, entity purchase or otherwise, is still appropriate post-Connelly.
Evaluate Ownership Structures: Consider transitioning to cross-purchase or hybrid agreements, or establishing a life insurance LLC, to mitigate tax implications.
Adjust Policy Funding Levels: Ensure life insurance coverage purchased as part of your estate planning accounts for potential estate tax exposure, particularly if the federal estate tax exemption decreases in future years.
Incorporate Flexible Terms: Include adjustable valuation mechanisms, installment options, or buyout flexibility in the buy-sell agreement to accommodate tax law changes.
Case Study: Redefining Buy-Sell Strategies After Connelly
Scenario: ABC Corp., a closely held S corporation, is owned equally by two siblings, Mark and Lisa. Their buy-sell agreement requires the corporation to redeem shares upon a shareholder’s death, funded by $20 million life insurance policies owned by the corporation on each sibling’s life.
Problem: Mark dies, and the corporation uses the $10 million death benefit to redeem his shares. Under Connelly, the $20 million proceeds are added to the corporation’s value, inflating Mark’s taxable estate to $30 million (50% of each of the $40 million appraised value plus $20 million insurance proceeds). The estate faces a $6,404,000 estate tax liability, reducing the funds available for Mark’s heirs.
Solution:
The agreement is restructured as a cross-purchase plan. Mark’s policy is transferred to Lisa, who becomes the owner and beneficiary. Upon Mark’s death, Lisa uses the $10 million proceeds to purchase his shares directly, avoiding the corporate valuation issue.
Alternatively, an LLC is formed to hold the policies. The LLC owns, administers, and allocates the death benefits proportionally, ensuring seamless funding without increasing the corporation’s value.
If You Need Help, Ask
The Connelly decision serves as a reminder that tax laws can have profound implications for business succession planning. For business owners, the key to navigating these changes lies in proactive review and restructuring of buy-sell agreements. Leveraging strategies like cross-purchase agreements, hybrid arrangements, or life insurance LLCs can help minimize tax exposure while preserving the continuity and financial security of the business.
Engaging experienced advisors ensures that your plan is not only tax-efficient but also aligned with your long-term goals and legacy. At Life Insurance Strategies Group, LLC, we do not sell products. We help our affluent individual and institutional clients make decisions regarding complex matters involving life insurance. Visit us at www.lifeinsurancestrategiesgroup.com to reach out.