A recent Supreme Court ruling has significant implications for closely held businesses — particularly how buy-sell agreements funded by corporate-owned life insurance are valued for estate tax purposes. If your succession plan relies on this structure, here is what you need to know.
The Background
Two brothers, Michael and Thomas, co-owned a family business and had a buy-sell agreement in place. The agreement gave the surviving sibling the option to purchase the deceased’s shares upon death. If that option was not exercised, the company itself would redeem the shares — funded by a corporate-owned life insurance policy.
When Michael passed away, the company received a life insurance payout and used it to redeem his shares. Michael’s estate valued those shares at the redemption price. The IRS disagreed.
The IRS Argument and the Court’s Decision
The IRS argued that the life insurance proceeds, even though earmarked for a share redemption, increased the company’s overall value before the transaction occurred — and that this higher value should be reflected in the deceased shareholder’s estate for tax purposes.
In a unanimous decision, the Supreme Court sided with the IRS. The Court held that a corporation’s obligation to redeem shares does not reduce the company’s value for federal estate tax purposes. Life insurance proceeds received by a company upon a shareholder’s death are considered a company asset, which can increase the taxable value of the deceased’s shares.
Why This Matters
The Connelly decision has direct, tangible implications for closely held business owners:
- Higher estate tax liability. If your buy-sell agreement is funded by corporate-owned life insurance, your business may be valued higher for estate tax purposes than previously anticipated — potentially creating a significant tax burden for your heirs.
- Buy-sell agreements need review. The “set it and forget it” approach is no longer viable. Existing agreements must be revisited and potentially restructured.
- Precise language is critical. The case underscored the costly consequences of ambiguous contract language in buy-sell agreements.
Strategies to Consider
Business owners should explore alternative structures in light of this ruling:
- Cross-purchase agreements. Rather than the company owning life insurance policies, individual shareholders own policies on each other. When a shareholder dies, the surviving shareholders use the proceeds to purchase the shares directly — keeping the insurance proceeds out of the company’s valuation.
- Irrevocable Life Insurance Trusts (ILITs). These trusts own the life insurance policies, removing the proceeds from both the company’s and the individual’s taxable estate.
- Proactive estate planning. Utilizing current estate tax exemptions and gifting strategies takes on added importance given this new landscape.
Action Steps
- Consult your legal counsel, financial advisor, and tax professional — this is not a do-it-yourself situation.
- Review your buy-sell agreement carefully, with particular attention to provisions involving corporate-owned life insurance and redemption obligations.
- Explore whether a cross-purchase agreement, ILIT, or other structure is a better fit for your business.
- Re-evaluate your business valuation to understand the estate tax impact under the new ruling.
The Connelly decision is a reminder that the legal and tax landscape is constantly evolving. Proactive planning is the best way to protect your business and ensure a smooth, tax-efficient transition for future generations.
Have questions about your succession plan? Contact us at loyaltyalliance.com.