I’ve helped dozens of closely held businesses figure out and ultimately document (either in an Operating Agreement or a Shareholders’ Agreement) the transfer of ownership shares or units upon the death of one or more of the owners. One super common vehicle is to use insurance (aka “key person” insurance) to help fund a buyout (redemption). It’s also quite common for the company to be a beneficiary so it can use the insurance money to complete the buy back. It used to be a win-win—the company can easily redeem the shares without undue financial strain and the insurance money would be tax-free. But not anymore. The U.S. Supreme Court upended that framework in June in a not too highly publicized case called Connelly v. United States. What you don’t know about its decision could hurt you. Just ask the estate in Connelly, which ended up owing the IRS another almost $900,000 in estate taxes. BIG GULP—and not the kind that comes in a cup at Circle K.
What’s the Deal with the Connelly Case?
Michael Connelly owned a big chunk of Crown C Supply Corporation together with his brother. When he died, the company as beneficiary used a $3.5 million life insurance policy to buy back his shares, pursuant to a Buy-Sell Agreement. The estate reported these shares based on their fair market value to the IRS as having a $3 million value for tax purposes. But the IRS had other ideas. It argued persuasively that the insurance proceeds should be included in the valuation, giving Michael Connelly’s Crown C shares a value over $5 million. The estate filed suit and the Supreme Court ultimately sided with the IRS, ruling in a majority decision that those insurance proceeds do count towards the company’s value for estate tax purposes.
What Does This Mean for Your Business?
1. Higher Estate Taxes: If your business has a similar setup, this ruling could mean a bigger estate tax bill. If your business’s value is over the exemption threshold, you might be looking at some extra taxes.
2. Time to Rethink Your Buy-Sell Agreements: It’s a good idea to take another look at your Buy-Sell Agreements (or your Shareholders’/Operating Agreements that contain Buy-Sell provisions). This decision might mean you need to restructure current agreements or explore other options. Here are a few strategies to consider:
- Cross-Purchase Agreements: Instead of the corporation holding life insurance policies, individual shareholders can hold policies on each other. This arrangement, known as a cross-purchase agreement, keeps life insurance proceeds out of the corporation’s value, potentially reducing estate tax liability. Although, this can get kind of crazy in closely held businesses with multiple owners.
- Life Insurance LLC: Establish a limited liability company (LLC) to hold life insurance policies, which can centralize policy administration and keep proceeds outside the corporation’s value. This method involves the LLC owning the policies, with business distributions used to pay premiums. This is honestly likely to be pretty popular with planners, but it adds complexity for sure.
- Escrow Arrangements: Using a trustee or escrow agent to hold stock certificates and life insurance policies can simplify administration and ensure that proceeds are not included in the corporation’s estate valuation.
- Endorsement Split Dollar: Business owners can purchase policies on their own lives and endorse the death benefit to co-owners through a split dollar agreement, keeping the proceeds out of the corporation’s estate.
3. Keep Your Valuation Current: In Connelly, it didn’t help that the company hadn’t kept its valuations up to date. If your documents call for an independent appraisal with annual updates, get them done. I know it’s annoying, but you will diminish your own arguments if you don’t follow your own agreement.
4. Looking Ahead: Keep in mind that the estate tax exemption is set to drop after 2025 (from $13.61 million currently down to an estimated $7 million), so this could affect even more businesses. Business owners should consult with tax and legal advisors to align their corporate agreements with current laws and court rulings. Regular reviews and updates are essential to adapt to evolving legal landscapes.
The Connelly decision is a wake-up call for business owners to get proactive about estate and succession planning. It’s also likely to embolden the IRS, who had a victory here and knows there are a lot of these out there. By dealing with this change now, you can manage your estate tax liabilities better and ensure a smooth transition when the time comes. Please reach out to us if you need assistance amending your current structures and understanding how this landmark ruling may impact your business. This is absolutely one of those areas where your business lawyer, tax planner or tax lawyer, and your estate lawyer should all be talking. More thinking on this will likely produce a better outcome.
