The Supreme Court Likely Shook Up Your Buy-Sell Agreement

The U.S. Supreme Court’s recent decision in the Connelly case significantly impacts businesses that utilize buy-sell agreements funded by life insurance for shareholder succession. This ruling may affect estate tax liabilities and the valuation of company shares when a shareholder dies, prompting companies to reconsider their agreements.

Background on Buy-Sell Agreements

Buy-sell agreements are essential for business continuity in case a shareholder passes away. In the Connelly case, brothers Thomas and Michael owned Crown C Supply and established a stock redemption agreement. The corporation purchased life insurance on each brother’s life, with proceeds designated to buy back shares from the deceased brother’s estate.

When Michael died in 2013, the company used $3 million from the life insurance proceeds to redeem his shares. His estate reported this value on its federal tax return. However, the IRS contested this valuation, claiming that the company’s worth was actually $6.86 million, which included both the enterprise value and the life insurance proceeds.

IRS Dispute and Court Rulings

The IRS’s higher valuation resulted in increased estate taxes for Michael’s estate, which had a tax exemption of $5.25 million at the time. After paying the tax, Thomas, as the estate executor, pursued a refund, asserting that the insurance proceeds should not inflate the estate’s value. However, both the district court and the U.S. Court of Appeals for the Eighth Circuit sided with the IRS.

On June 6, 2024, the U.S. Supreme Court unanimously upheld the lower courts’ decisions, concluding that life insurance proceeds are considered an asset of the company, thus increasing the value of the deceased’s shares. This means the required redemption under a buy-sell agreement does not decrease the shares’ value for estate tax calculations.

Implications of the Connelly Decision

The Connelly ruling has crucial implications for how life insurance impacts estate valuation in buy-sell agreements:

1. Increased Estate Tax: The life insurance proceeds can elevate the overall company value, resulting in a higher estate tax liability upon a shareholder’s death.
2. Valuation Method Reassessment: Companies may need to reassess how they value shares in light of this ruling, particularly if they have significant life insurance policies involved in their agreements.

Recommended Actions

In light of the Supreme Court’s decision, business owners should consider several actions regarding their buy-sell agreements:

• Review Existing Agreements: Companies should closely evaluate their buy-sell arrangements, particularly those funded by life insurance. Understanding how these agreements are structured can help anticipate potential tax consequences.
• Consider Estate Tax Thresholds: If the value of the estate is below the federal estate tax exemption (currently $13.61 million, but set to decrease after 2025), maintaining the insurance-funded redemption agreement may be reasonable. However, states may have lower exemption limits, necessitating awareness of state tax implications.
• Explore Cross-Purchase Agreements: A viable alternative to redemption agreements is a cross-purchase agreement, where each owner purchases life insurance on the other owners. This method avoids inflating company value for estate tax purposes, as the insurance proceeds do not factor into the company’s overall valuation.
• Utilize Cross-Purchase Trusts or Insurance LLCs: If managing multiple policies on various shareholders proves complex, businesses might consider forming a cross-purchase trust or an insurance LLC. These structures simplify policy management while ensuring that the intended financial arrangements are maintained.

Conclusion

The Supreme Court’s Connelly decision fundamentally alters the landscape for businesses with life insurance-funded buy-sell agreements. By treating life insurance proceeds as company assets, the ruling raises important questions about estate taxation and share valuation. Business owners are encouraged to consult with estate planning and tax advisors to ensure their agreements align with their financial and succession planning goals, considering alternatives like cross-purchase agreements that may better suit their needs.