On June 6, 2024, the U.S. Supreme Court unanimously held in Connelly v. United States, that life insurance proceeds received by a closely held corporation which are used to fund the redemption of a deceased shareholder’s stock should be taken into account when determining the value of a deceased owner’s stock for estate tax purposes.
This case involved Michael and Thomas Connelly, brothers and business partners who owned a roofing company. Michael owned roughly 75% of the shares with Thomas owning the remainder. Wanting the business to remain in the family, Michael and Thomas had an agreement that upon the death of either of them, the survivor would have the option to purchase his brother’s shares. The agreement further asserted that if the survivor declined to purchase the shares, the company itself would be required to redeem them. To ensure the possibility of this redemption, life insurance policies valued at $3.5 Million were purchased on each Michael and Thomas in the name of the company.
Upon Michael’s death, the brothers’ corporation was worth a value slightly under $4 million as an operating business. Accordingly, the estate valued Michael’s 75% of the shares at approximately $3 million (75% of $4 million) and the company paid the estate $3 million to purchase the shares using the proceeds from the $3.5 million dollar policy that had been taken out on Michael’s life. This transaction was reported on the estate tax return for Michael’s estate which was in turn audited by the IRS. The IRS determined the corporation was worth about $7 million and counted the additional $3 million in life insurance proceeds as an asset of the corporation without any corresponding reduction due to the obligation to purchase Michael’s shares. The IRS held that Michael’s shares were worth slightly more than $5 million (75% of $7 million).
The tax issue in the Connelly case involved the value of the company and Michael’s shares at death and whether the life insurance proceeds payable to the corporation would be included as an asset of the corporation for valuation purposes. Ultimately, the conclusion was affirmative that such life insurance proceeds would be considered an asset of the corporation for valuation purposes – a major shift from their treatment in the past.
Generally, buy-sell agreements are structured either as i) cross-purchase agreements where the surviving owner buys the deceased owner’s shares directly from their estate, or ii) redemption agreements where the business itself purchases the deceased owner’s shares. Often the purchase prices under the agreements are funded by life insurance policies on the owners. For cross-purchase agreements, each owner owns the life insurance on the other business owner’s life. In the redemption agreement, the company owns the life insurance on the owners. Based on Connelly, it now appears these types of agreements will be treated differently for estate tax purposes.
The tax issue in Connelly could have been avoided if the brothers had used a cross-purchase agreement instead of a redemption agreement. What are the options for corporations or other entities that have redemption agreements in place that are funded by life insurance?
One possible solution is moving the existing life insurance from the company to the owners. The challenge of solving this issue by simply moving the life insurance to the owners under a cross-purchase agreement arrangement is that transferring the life insurance ownership could trigger the transfer-for-value rules under the Internal Revenue Code that makes the proceeds taxable on receipt for income tax purposes. However, one exception to the transfer-for-value rules makes it possible to transfer a life insurance policy to a partnership owned by the insured persons.
A better solution would be to simply start new insurance under a cross-purchase agreement. Though for many individuals this will not be a valid option due to many factors including: cost for new insurance, cash value taxation, and insurability of the owners.
What can be done if new insurance is cost prohibitive, but transfer-of-value rules will apply if the policy is shifted from the company to the owners? One may consider transferring the life insurance to a new LLC, created for the purpose of holding the life insurance, thus moving the insurance away from the company while also avoiding the transfer-for-value rules. The LLC could then have an agreement controlling the ownership and distribution of proceeds in the event of a death. While this seems to be the ideal solution at present, considering the Connelly ruling, there is no guarantee the IRS will continue to recognize the transfer of the insurance to the LLCs as a legitimate transfer for business purposes and outside the estate of the deceased owner for estate tax purposes. When structuring your buy-sell agreements and business succession plans, seeking sound legal counsel could be the difference between paying millions in tax, and ensuring a seamless and cost-effective transition. Contact our experienced corporate and estate planning attorneys at Manning Fulton for guidance on these essential structuring decisions.
