The Supreme Court Likely Shook Up Your Buy-Sell Agreement
Article originally posted by the Bradford Tax Insitute.
Does your company have a buy-sell agreement that uses life insurance to redeem your shares if you die?
If so, a new groundbreaking decision by the U.S. Supreme Court could have an impact on you (or your heirs, if you are the one who dies).
- It’s possible, because of the Supreme Court’s decision, that the life insurance proceeds could cause an increase in your estate tax.
- Depending on how your buy-sell agreement values the company, the Supreme Court’s treatment of life insurance proceeds could cause a valuation result different from what you expect.
- The Supreme Court decision may require you and your fellow shareholders to rethink your buy-sell agreement.
Okay, the Supreme Court made this ruling in the Connelly case. Let’s find out how Connelly possibly upended your corporate redemption buy-sell agreement and what you can do about it.
What Happened
The Connelly brothers, Thomas and Michael, owned all the stock in Crown C Supply, their building supply business.
They wanted to ensure that the business would continue to operate smoothly without disruption if something happened to either brother.
The brothers planned for the risk of either of them dying by having their corporation create and fund a stock redemption agreement. Crown purchased life insurance on each shareholder’s life, and the proceeds were to be used to redeem the deceased shareholder’s shares.[1]
Michael died in 2013.
The company bought Michael’s shares using $3 million of the life insurance proceeds per the redemption agreement.
Michael’s estate filed a federal tax return listing the value of his shares at $3 million—the value proclaimed by the redemption agreement.
Hello, IRS
Unfortunately for the estate, the IRS disagreed. It said that at the time of death, the company was worth $6.86 million (the $3.86 million enterprise value plus the $3 million life insurance value).
In 2013, when Michael died, the estate tax exemption was $5.25 million per individual. The IRS change in the valuation of the business, just one of the estate’s assets, caused Michael’s estate to pay more in estate taxes.
The estate paid the tax. Then Thomas, the surviving brother and estate executor, sued for a refund in U.S. district court.
It didn’t do much good, because the court agreed with the IRS and held that the company’s value had increased due to the life insurance proceeds. Per the court and the IRS, the required redemption did not reduce the value of the shares for estate tax purposes.[2]
However, Thomas was not about to give up. He took the case to the U.S. Court of Appeals for the Eighth Circuit, where he again lost.[3] Thomas then took the case to the U.S. Supreme Court.
On June 6, 2024, the Supreme Court issued a unanimous opinion in agreement with the IRS, the district court, and the appellate court.[4]
The Supreme Court’s decision is now the law of the land—at least until Congress changes the rules. Now, because of Connelly, a buy-sell redemption agreement liability can no longer offset the life insurance proceeds on your company’s balance sheet for estate tax purposes.
After Connelly, life insurance money is considered an asset of the company. This increases the value of the deceased person’s shares before they are bought back. As a result, the redemption cost is higher, and more estate tax could be due.[5]
What to Do About It
First, you should review the structure and terms of your buyout arrangement.
If your buy-sell agreement uses company-owned life insurance, the Supreme Court decision affects you.
If the value of your estate is safely under the federal estate tax threshold (currently, the exemption is $13.61 million[6]), you may want to leave the insurance-funded redemption agreement in place.
Even though life insurance may add to your company’s value, no federal estate tax would be due if you are under the exemption limit. But some states have lower limits, and you could still owe state taxes.
Note. The Tax Cuts and Jobs Act increase in the federal estate tax exemption expires on December 31, 2025. Thus, beginning in 2026, the tax code, as currently written, will cut the estate tax exemption in half.
An Alternative
You might want to change your arrangement to a “cross-purchase” agreement. Here, each owner buys insurance on the other owners and uses the proceeds to purchase the shares of the deceased. With this type of structure, the value of the insurance does not affect the company value, as it did in Connelly.
With a cross-purchase agreement funded with life insurance,
- you receive the life insurance monies free of federal income tax,
- you use the life insurance money to buy the shares of the deceased, and
- your stock basis in the company increases by the price you paid for newly acquired shares.
Changing an existing redemption agreement may prove too difficult. It’s certainly tricky. And you definitely need good life insurance and estate planning advice to make it happen.
If you are concerned that not all the owners will pay the premiums to keep the insurance in force or that the number of owners is too numerous to monitor effectively, you might consider a cross-purchase trust or an insurance LLC. The advantage here is that rather than having each shareholder own policies on all the other owners, there’s only one insurance policy per owner.
Takeaways
The Supreme Court’s Connelly decision means life insurance money paid to the company to redeem the shares of the deceased shareholder increases the company’s value for estate tax purposes.
If you are an owner involved in a business agreement that uses life insurance to fund a redemption of ownership when one owner dies, it’s time to spend some time with your estate tax advisors to make sure what happens at death is what you expect to happen.
After Connelly, your redemption buy-sell may be the wrong vehicle. It’s possible that a cross-purchase agreement is a better alternative for you.
1 For more details on a redemption agreement and the alternatives, see Your Co-owned Business Probably Needs a Buy-Sell Agreement. Before Connelly, companies treated the redemption amount they were required to pay as a liability, which reduced the value of the business when the company redeemed the stock. Estate of Blount v Commissioner, 96 AFTR 2d 2005-6795 provided this guidance.
2 Thomas A. Connelly v U.S., 128 AFTR 2d 2021-5955.
3 Thomas A. Connelly v U.S., 131 AFTR 2d 2023-1902 (CA8), 06/02/2023.
4 Thomas A. Connelly v U.S., 133 AFTR 2d 2024-1680 (S Ct, 6/6/2024).
5 Reg. Section 20.2031-2(f)(2) requires non-operating assets such as life insurance, when they are not included in the fair market value of the business, to be added to the value of the entity.
